💱 What Is an Exchange Rate?
Definition: Exchange rate.
Floating exchange rate.
In a floating system, currencies are traded 24/7 on the foreign exchange (forex) market. The price fluctuates constantly based on relative demand and supply.
Appreciation = currency becomes stronger (can buy more foreign currency). Depreciation = currency becomes weaker (can buy less foreign currency). These terms apply to floating rates.
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⚖️ Floating Rates: Pros and Cons
- ✅ Automatic adjustment — trade imbalances self-correct. A current account deficit → depreciation → exports become cheaper → deficit reduces.
- ✅ Monetary policy freedom — the central bank can set interest rates for domestic goals (inflation, growth) without worrying about maintaining the exchange rate.
- ✅ No need for large foreign currency reserves — the government doesn't need to defend a fixed rate.
- ❌ Uncertainty and volatility — exchange rate fluctuations create risk for international traders and investors.
- ❌ Speculative attacks — 'hot money' flows can cause sharp, destabilising movements.
- ❌ Imported inflation — a depreciating currency makes imports more expensive, fuelling cost-push inflation.