Floating Exchange Rate: Definition & Examples

Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

When a business buys goods from another country, it needs to know how much it will pay in its own currency. In this lesson, you will learn about the floating exchange rate.

What Is a Floating Exchange Rate?

Let's meet Ms. Sparkle, who owns a craft store. She frequently orders beads from suppliers outside the country since there is no domestic supplier. The amount of money she pays for these purchases in her own currency varies and she doesn't understand why. Let's see if we can help Ms. Sparkle understand this situation.

A floating exchange rate is one whose value changes, or floats, based on a number of factors, such as the supply and demand for the currency on the open market and general economic conditions. For example, if the market demand for a currency is high, then its value will increase, and if demand is low, then the value of the currency will decrease.

The opposite of a floating exchange rate is a fixed exchange rate, where a country links its currency to that of another country or to another standard, such as gold. Most countries adopted a floating exchange rate in the early 1970s after using a fixed exchange rate for decades.

Under a floating exchange rate, a country's currency floats, or changes, from day-to-day, and this fluctuation has an impact on businesses that export their own products (ship them outside the country) and/or import other products (bring products into the country). Say Ms. Sparkle lives in country A and purchases her bead products from country B, which uses a different currency. If country B's currency rises in value compared with country A's, then Ms. Sparkle will pay more for the goods that she imports into the country.

The reverse is true if Ms. Sparkle exports her finished goods to country B. If her country's currency is weaker than that of country B, then anyone purchasing her products from country B would be able to purchase her beads at a lower price. In this situation, Ms. Sparkle's products would be in high demand because they would represent a good deal for country B's purchasers.

Implications for Business

Ms. Sparkle will want to minimize the risk of currency changes faced by her business. One way to reduce this risk is to purchase only from domestic suppliers, where she would not encounter any currency exchange differences.

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