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Highlights
- Central banks influence foreign exchange rates through currency purchases or sales.
- This intervention maintains stability and order in foreign exchange markets.
- Also known as foreign-exchange market intervention.
A floating exchange rate system is a mechanism where the value of a nation's currency is determined by the forces of supply and demand in the foreign exchange market. Unlike fixed exchange rate systems where governments peg their currency value to another major currency or a basket of currencies, floating exchange rates fluctuate freely. This fluctuation is influenced by various factors such as interest rates, inflation, political stability, and economic performance.
In this system, central banks play a crucial role in ensuring that the exchange rates do not become too volatile, which could harm the economy. They achieve this by purchasing or selling foreign currencies in the market. This action is known as foreign-exchange market intervention. The primary objective of this intervention is to influence foreign exchange rates or to maintain orderly foreign exchange markets.
Central banks buy their own currency to increase its value when it depreciates excessively, and they sell it when it appreciates too much. This strategic buying and selling help stabilize the currency's value, preventing extreme fluctuations that could affect international trade and investment. For example, if a country's currency depreciates significantly, it can make imports more expensive and contribute to inflation. Conversely, if the currency appreciates too much, it can make exports less competitive.
One of the advantages of a floating exchange rate system is that it allows for automatic adjustments in the balance of payments. When a country has a trade deficit, its currency depreciates, making exports cheaper and imports more expensive. This helps in correcting the trade imbalance. On the other hand, a trade surplus causes currency appreciation, which balances the payments by making exports costlier and imports cheaper.
However, the floating exchange rate system also has its challenges. It can lead to increased volatility, which poses risks for businesses engaged in international trade. This uncertainty can affect profit margins and complicate financial planning. Additionally, speculative activities in the foreign exchange market can lead to excessive currency fluctuations.
To mitigate such issues, central banks intervene strategically. This intervention is not meant to fix the currency at a specific value but to smooth out excessive volatility and ensure orderly market conditions. These interventions are often temporary and are used sparingly to avoid market distortions.
In conclusion, the floating exchange rate system provides flexibility and automatic economic adjustments through market forces. However, it comes with the risk of volatility and speculation, which can impact economic stability. Central banks play a pivotal role in moderating these fluctuations through foreign-exchange market interventions. By strategically buying or selling currencies, they maintain order in the exchange markets and support national economic objectives.
