A floating exchange rate is one where the price of the currency in question is set by the free forex market. This market sets the values of currencies using available supply and relevant demand as measured against other currency pairs. This is the opposite of a fixed exchange rate, where a national government mainly or entirely sets the rate for the country’s currency. Most of the major economy currencies in the world have been free floating since the Bretton Woods exchange system irreparably broke down in 1971.
With a free floating exchange rate system in place, there will be countless short term movements in a currency value that result from investor and trader speculation and disasters or even rumors which are man made or naturally occurring. The longer term movements in these floating currencies occur because of the differentials in between interest rates and economic strength as relative to nations’ peers. There can also be wild short term moves that happen because of central bank direct intervention in the currency markets, even while the system is still a free floating exchange rate environment.
The soon to be victors of World War II met in Bretton Woods Resort in New Hampshire in July of 1944 to hold the famed Bretton Woods Conference. The 44 nations at this key conference created the World Bank and International Monetary Fund. They also laid out specific guidelines to set up an exchange rate system that was fixed.
The scenario they established laid out a $35 per ounce gold price that all countries pegged up to alongside the dollar. The range of adjustment was limited to only plus or minus one percent at the time. This conference enshrined the U.S. dollar as the world’s reserve currency. Central banks were able to engage in interventions by selling or buying dollars in order to stabilize or tweak exchange rates.
The system worked well until 1967 when fractures began to appear. That year, there was a gold run as well as an attack on the value of the British pound. This resulted in a shocking 14.3% sterling devaluation. Four years later, as numerous countries around the world watched the U.S. print limitless new paper dollars they began cashing in their dollars for gold in record numbers.
Faced with an impending shortage of American gold reserves in 1971, then-President Richard Nixon felt like he had no choice but to remove the United States from the gold standard. Only two years later, the Bretton Woods currency system had totally collapsed. Those currencies which had participated in the system morphed over to a floating exchange rate system instead.
Central banks are able to purchase and sell their own currency in a free floating exchange rate system. They do this to influence the rate of exchange for one of several reasons. They might want to calm down a volatile currency market. They could also wish to cut the currency exchange rate dramatically in order to stimulate exports to other countries.
The world’s most important central banks often work in concert to affect the desired results. This includes the G-7 countries of the United States, the United Kingdom, Japan, Italy, Germany, France, and Canada. By working together, they are able to magnify their individual impacts on the currency markets.
These interventions do not always prove to be successful and are usually only short term in duration. Sometimes central banks choose to indirectly interfere in the markets by lowering or raising their interest rates instead to change the quantity of investor funds moving into their nation.