WHAT ARE FREELY FLOATING CURRENCIES?


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A part from a few misguided misers like Ebenezer Scrooge, no one wants a currency “to have and to hold, until death do your part.” Currencies are used to buy goods and services, both at home and abroad, and their value is determined in many different ways.

It used to be that a currency’s value was fixed by the government or was linked to some item of value. In the United States, for example, until 1971, dollars could be converted into gold. This gold standard was meant to guarantee that currencies would always have a certain value, determined by the amount of gold held in each country’s vaults. This is no longer the case-at least not United States.

Most countries abandoned the gold standard in the 1930s, when insufficient gold reserves forced governments to adopt a system of fixed exchange rates where each country’s government decided on its own what its currency was going to be worth. The British Government, for example, had decided that pounds would be exchanged into U.S dollars at the rate of $2.40 per British pound. When the Smithsonian Agreement of fixed exchange rates collapsed in 1973, currencies were allowed to “float” on the international markets. One day a dollar could be worth ten Swedish kroner, the next day it could be worth ten Swedish kroner, the next day it could be worth eleven. From then on, the markets would decide what the world’s major currencies were worth.

 What determines the “prices’ of a currency? Just like concert ticket on the night of a sold out-out performance, a freely floating currency’s price goes up when there is increased demand. It is hard to envision, but currencies are scarce commodities- just like apples and crude oil. Their price depends on supply and demand. When everyone wants to buy Japanese cars and stereo systems, for example, the “price” of yen tends to go up. This happens because importers in Paris and Minneapolis have to use their Euros and Dollars to buy Yen to pay for the increased Japanese imports. Likewise, if all Italian lira would eventually lose value as it is sold to buy dollars-which are then used to pay for Mickey Mouse T-shirts and Disney World admission tickets.

 All the world major currencies-from the Swiss franc to the yen to the dollar to the euro-area traded on the world foreign exchange, or forex markets. This free float system does not keep governments from trying to influence the value of their currencies from time, however. By buying or selling a large amount of currencies- or by raising or lowering interest rate – a government is able to raise or lower the value of any currency. This system, sometimes called a “dirty float”, is usually only a stopgap measure.

 Like trying to reverse the flow of water, it is very difficult to halt the slide of currency once traders and investors decide it is headed for a fall. Because of the enormous amount of currency traded every day on the world foreign exchange market- it had reached 1.5 trillion dollars by the year 2020-interventions by central banks are often just a drop in the bucket.

 The values of free-floating currencies are influenced mainly by economic and political events-and sometimes by the sheer speculation of individual traders. Foreign exchange traders may bet that a currency will increase or decline in value- just as a commodities trader bets that wheat or pork bellies will go up or down at some point in the future. Basically, if the interest rates look set to rise in Tokyo, meaning higher return for yen-based investments, traders may rush to sell dollars and euros and buy yen, expecting other investors to follow suit.

 No one knows for sure what direction currency markets are going to take. Since economic information is now immediately available to everyone on global market, exchange rate forecasts are pure speculation. At any given point in time, about half the traders and investors in the currency markets think a particular currency will go up, and the other half thinks it will go down. If it were any different, the side “in the know” would keep buying up a currency until it reached a new equilibrium level.

 

 During periods of economic and political turmoil, some traders and investors turn to a particular currency as a “refuge”. When political unrest threatens to erupt in the Far East, for example, traders may rush to buy hard currencies such as Swiss Franc or the U.S dollar, which are expected to hold their value in times of trouble.


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