Foreign Exchange Floating Rate Systems

Foreign Exchange Floating Rate Systems | Finance Train

In a floating rate exchange system, a supply and demand relationship exists between the price of currency Y against currency X and the quantity available of currency Y.
Moving along the currency demand curve (or changes in quantity demanded):
- Exports Effect – citizens of country X do not demand currency Y, rather they demand goods and services from country Y. If currency Y is valued low, then citizens of country X will buy cheap goods and services from Y. This will require X to accumulate more Y currency, driving up its price. This relationship shows how demand for foreign currency is a derived demand.
Expected Profit Effect – as the price of currency Y drops relative to currency X, the potential profit from owning currency Y in anticipation of a rebound becomes higher. This is the basic law of demand, in that currency investors may buy more of currency Y as it becomes cheaper if they expect that prices will later rise.
Moving along the currency supply curve (or changes in quantity supplied):
- Imports Effect – As currency Y appreciates relative to X, residents of country Y will want to import more goods from country X and to do so they will need to supply increasing quantities of their currency to buy goods from country X.
- Expected Profit Effect – As currency Y appreciates relative to X, its profit potential diminishes and currency market participants will look to sell; this is the opposing force of the expected profit effect on the demand side.

Factors that SHIFT the demand curve in a floating rate environment:
- Changes to the difference (spread) in interest rates between countries.
- Changes in expectations about the future exchange rate.
Factors that SHIFT the supply curve in a floating rate environment (same as demand shifts):
- Changes to the difference (spread) in interest rates between countries.
- Changes in expectations about the future exchange rate.
While the factors that shift the supply and demand curve are the same, they work in opposite directions, thus demand may increase, when supply simultaneously decreases and quantity remains unchanged – the same amount of equilibrium quantity at a higher price.
Changes to exchange rate expectations can be caused by:
- Purchasing Power Parity – this is the idea that the currencies exchanged should have equal purchasing power in their respective countries. When the inflation rate of country Y is expected to increase relative to country X, then market participants will expect country Y to depreciate in value.
- Interest Rate Parity – this is the idea that all risk free assets (US Treasury bonds and their foreign equivalents) should earn the same real rate of return, irrespective of currency denomination. Interest rate spreads across the government bonds of countries reflects a difference in nominal rates of return. When nominal spread of country Y widens (increase) versus country X, market participants should expect the future price of currency Y to decrease relative to the current exchange rate. Changes in expectation about inflation differential should explain the differences in nominal interest rates across countries, when currency values float.
Currencies of countries with high expected inflation rates show a tendency to depreciate over time.
When a country has a comparatively high real interest rate, it will attract foreign investment, which increases the demand (shifts the demand curve rightward) for that currency and causes it to appreciate in value.
As a country realizes it’s expected economic growth, it will import more and thus slow the currency appreciation experienced during the early part of the growth phase.