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what it is, what it affects, the system, in terms of inflation, the pros and cons

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A floating exchange rate is one of the methods of managing the exchange rate. Prices for goods, inflation in the country and a number of other factors depend on it. The exchange rate is controlled by the Central Bank.

What is the exchange rate

In Russia, the EUR/RUB currency pair is used. EUR is euro, RUB is ruble. When EUR is indicated first in a currency pair, and RUB is indicated second, then the value of the ruble against the euro is implied. So the EUR/RUB currency pair is 70 rubles, which means that one euro can be bought for 70 rubles.

The exchange rate is used by individuals and legal entities. Individuals (citizens of the country) use the exchange rate to buy or sell foreign currency, to accumulate (create a financial cushion) and spend money abroad. Legal entities (businessmen and entrepreneurs) for the purchase and sale of goods abroad, payment of bills, transactions, in settlements with counterparties.

What affects the exchange rate

The national currency of a state is influenced by many factors. Often, the growth is influenced by the popularity of the country in the international political and social arena, the amount of currency, the activities of the Central Bank of the state. In addition, the price is always affected by such emergencies as: war, crisis, pandemic, global cataclysms, and so on.

Floating exchange rate - pros and cons

One of the most important factors on which the growth of the national currency depends is supply and demand. Any currency on the international financial market appears as an ordinary commodity that a person can buy. A lot depends on the amount of currency and how many people want to buy it. The price rises if the number of potential buyers grows and decreases if there are fewer people. The price indicated on the international currency exchange can also be affected by whether any sanctions and events that are unfolding within the country are imposed on the state.

Floating exchange rate - pros and cons

Another reason that affects the rise in prices is the actions taken by the Central Bank. It is this organization that regulates the price of the currency on the financial exchange and the growth and fall of national reserves inside and outside the country depends on its actions. In case of incorrect influence of the Central Bank, not only the national currency, but also the securities owned by the state may suffer.

Although the Central Bank tries to always control the price of the currency, there are cases in which state assets do not lend themselves to the firm hand of the government. As a rule, these are emergencies caused by severe epidemics, natural disasters, wars, discord between several countries, internal coups. In this case, most of the foreign investors withdraw their capital, there is an outflow of invested funds, due to which the currency begins to lose value, while the currencies of neighboring countries inevitably grow.

The price of the currency is formed in the exchanges, the Central Bank and ordinary banks within the country. Everything works as follows:

  1. On the stock exchanges, the exchange rate is considered the most fair. The price arises on the basis of economic transactions carried out by traders, due to which the value of the currency directly depends on its need and significance at the moment. The rate offered by financial exchanges is considered the cheapest. Thanks to the data offered by the exchange, banks set their own prices for the purchase of currency.
  2. The Central Bank tries to set and regulate the price of the currency every day. The rate set by the organization is the basis that each financial institution is required to use when making its transactions. At this rate, the population will not be able to buy dollars or euros. The course is used when maintaining documentation in the accounting department of various organizations, when reporting to customs services and other places.
  3. The lowest link in the country’s economy, which has the right to set the exchange rate, is a commercial bank. When setting its own course, the organization relies on the data that the financial exchange shows. This is done so that the price is not too low or too high. In a normal situation, the price of a floating exchange rate is set depending on the basic rules of the economy: supply and demand.

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Why does the exchange rate float?

Floating exchange rate - pros and cons

There are several regimes for managing the exchange rate and which one is applied in the country depends on the Central Bank and the government. If the state does not try and does not use instruments to influence the exchange rate, then the regime of governance is called free floating. During the economic crisis or other circumstances, the state can intervene and use tools to influence the exchange rate, then it is called controlled floating. But if the state rejects the previous options and completely controls the exchange rate, then it is called fixed. Examples of such policies are:

  • Free floating rate. Its price is determined by market factors, and the Central Bank makes no attempt to intervene in its value;
  • managed course. The Central Bank uses one or more instruments of influence. For example, the currency corridor, in economic theory, the term refers to the price range at which the exchange rate should not go beyond it. If, in a certain situation, it goes out of the price range, then the Central Bank uses other instruments of influence and stabilizes the exchange rate. So, with the help of foreign exchange intervention, you can change the amount of supply and demand;
  • Fixed rate. This method of management is well known to the citizens of the USSR. One or more foreign currencies can be used for regulation, the Central Bank pegs the national currency to the foreign one.

Floating exchange rate - pros and cons

In democratic countries it is impossible to apply a fixed exchange rate. This was the case in the USSR until 1990, when the country switched to market relations. Since then, much has changed, the Bank of Russia and the Central Bank tried many tools to influence the exchange rate until they switched to a freely floating exchange rate in 2014.

Exchange rate and inflation

These two concepts are closely related to each other. So, with a depreciation of the ruble (national currency) leads to an increase in inflation. This happens because the price of imported goods increases, followed by an increase in the average level of prices for goods. In economic theory, what is happening is called the pass-through effect. It should be noted that the resulting effect is most often incomplete, an increase in the exchange rate by 1% leads to a change in prices for goods by less than 1%.

Floating exchange rate - pros and cons

In the short term, the pass-through effect is of less importance in the economy; it has the greatest impact in the long term. A good example of the carryover effect happened in 2000. For example, an increase in the exchange rate by 10% led to the fact that food prices increased by 3%, in the first months, after some time, it increased to 6%. It was clearly seen how the instantaneous pass-through was 0.3, and the long-term 0.6.

Floating exchange rate - pros and cons

The incomplete carryover effect occurs for several reasons:

  1. Import. Importers who bring goods to Russia compete with entrepreneurs engaged in the production of exactly the same goods. In conditions of appreciation, they can increase the prices of goods in order to reduce costs, but in this case, citizens will buy goods from a domestic manufacturer and the importer will receive losses.
  2. domestic goods. Locally produced goods are traded only on the domestic market and exchange rate fluctuations do not affect the production and purchase of raw materials takes place at the same prices.
  3. Businessmen. Entrepreneurs do not want the demand for their product to decline and think that the appreciation is a temporary effect and everything will be restored soon.
Floating exchange rate - pros and cons
Transfer effect (example)

Transfer effectobserved in different years and in different countries. It happened when it arose in different time periods of one country. Observation of the pass-through effect allows economists to understand that an appreciation or weakening of the national currency leads to higher prices. A vivid example of this statement is 2014 in Russia. That year, oil prices plummeted, followed by a fall in the ruble exchange rate (oil prices and the ruble exchange rate were interconnected), then inflation in the country began to rise. According to statistics, by 2013 inflation was 6%, already in 2016 inflation was 16%.

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Floating exchange rate regime

Floating exchange rate - pros and cons

This management method was not chosen by chance, it’s all about market relations and the conditions for the movement of international capital. Now it is impossible to control inflation and manage the international exchange rate. The Central Bank is forced to choose one thing: inflation or the exchange rate.

The exchange rate regime was chosen after a double whammy: international sanctions and falling oil prices. In fact, the free-floating rate appeared on its own, since the authorities could not do anything, any steps could cause a deep crisis.

The exchange rate is not only the total value of a country’s money. The price of the national currency reflects the standard of living of the entire population of the country, its economic and social condition. A sharp change in price depends on the rating of the country in the international political arena, how wealthy the inhabitants of the state are, and much more. A sharp change for the worse or better implies that the country is experiencing a severe crisis, or vice versa, has recovered from it, and is setting its life on a prosperous track.

Viktor Mironov

Viktor Mironov

Higher economic, financial education. Financial analyst in a large financial company. Work experience 7 years.

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Helped investors place more than 500 million rubles. and over $200,000 in stock market instruments. Developed over 60 investment strategies. Experience in Forex - Basic and Series 1.0. Broker-dealer activity. The purpose of creating the fx-guidance website is to share with you My knowledge, experience and transfer my best practices on the topic of INVESTING IN THE STOCK MARKET, so I want to start with a FREE technical analysis course, thanks to which you will receive:✅Basic technical analysis system used by prof. investors ✅Learn to find the perfect entry and exit points ✅Begin to see long-term trends on the chart and understand the likelihood of further price movement

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