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Free Floating Currencies

Since 1978 free floating currencies were officially mandated by the International Monetary Fund. In other words, the currency may be traded by anybody and its value is a function of the current supply and demand forces in the market, and there are no specific intervention points that have to be observed. Of course, the Federal Reserve Bank intervenes from time to time to change the value of the U.S. dollar, but no specific levels are ever imposed.

Naturally, free floating currencies are in the heaviest trading demand. Free-floating is not an indispensable condition for trading but liquidity is.

Now a point to consider…

When a currency operates under a free floating exchange rate, its volatility rises. This is especially dangerous for emerging economies: when their liabilities are in foreign currency and their assets in local currency, the depreciation changes rapidly affecting the balance sheets and the financial health of the country’s economy.

Even though the free floating of the currencies can act as a stabilizing factor, the value of a currency is not 100% determined by what happens in the currency exchange market. Other factors play important roles, like employment rate, inflation rate, foreign investments, etc.

Currency reserves help protect investments of individuals and corporations during difficult times economically and politically speaking. After the World War II the reserve currency was the U.S. dollar. Now there are other reserve currencies available, like the euro and the Japanese yen. Of course, global conditions may add other currencies to this portfolio.

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