Supply and demand determine the value of goods and the value of currencies is not an exception to this basic rule of economics. The prices of all commodities and derivative goods vary in time, while the value of a particular currency fluctuates against the value of other currencies. A floating exchange rate means that the value of a currency is subject to market conditions and the foreign currency exchange regime allows it to fluctuate freely or almost freely. This is the main reason why the Forex exchange market is highly volatile and unpredictable at times.
Traditionally, the floating currency rates are preferred to fixed currency exchange rates, a view taken by most liberal economists. The floating rate, they insist, is reflecting fundamental factors like trade balances, inflation, unemployment, foreign investment, etc., which form the base for supply and demand of a particular currency, and thus form a real and correct market price. In today’s world, it is taken for granted that a developed economic market must use a floating system of currency exchange rates, which also diversifies the risks of a sudden currency exchange shock.
Some scholars claim that the above statement is not quite true but, in reality, all major world economies use floating currency rates. There are examples of fixed rate currency regimes in countries with growing market economies. The reasons for pegged currency regimes are more complex and have nothing to do with the market economy as a socio-political system.
The critics of the floating currency exchange regime most often emphasise the fluctuations of the currency rates as a major disadvantage of this type of regulation. A free-floating currency can experience major drops in its value against the other currencies, which will introduce instability in the local financial and economic system. As a result, the foreign investors could disappear, the trade imbalance to increase drastically and the country to enter a stage of galloping inflation. Such events have happened in history in under-developed countries causing an most apocalyptic scenario for a country with a floating foreign exchange regime.
Assuming that a certain economy is in good health and there is a functioning free market, the most appropriate foreign exchange regime would be a floating currency rate. The last financial crisis proved that a major currency could survive even in the most severe financial conditions and the currency exchange rates are able to adjust to various market conditions.
The floating currency rates are the base for the Forex market trading as well. All the major currency pairs formed by the euro, the U.S. dollar, the British pound, the Japanese yen and other currencies enjoy free-floating regimes. Movement in currency rates, for the large part, are a result of changes in the fundamentals and volatility is a characteristic feature of this sophisticated marketplace.
