Definition
A system in which the exchange rate is set freely, moment by moment, by the tug-of-war between people who want to buy a currency and people who want to sell it in the foreign exchange market. The government doesn't force a particular price. It lets the rate rise and fall naturally, like waves, with market supply and demand.
Money Prices Move Like an Apple Market
At a neighborhood market, when there's a bumper crop and apples are everywhere, the price drops. When the harvest is poor and apples get scarce, the price jumps. Under a floating exchange rate system, the price of money moves just like those apples. Say Korean companies export lots of semiconductors and cars and bring home piles of dollars. Dollars become common in the domestic market, so the dollar's value falls and the Korean won's value rises. On the other hand, when more people travel abroad or shop on overseas websites and want dollars, the dollar gets pricier and the won-dollar exchange rate goes up.
When the exchange rate moves freely every moment like this, a kind of automatic shock absorber kicks in for the national economy. Suppose Korean goods become less popular and exports shrink. Fewer people want won in the foreign exchange market, so the won's value falls. A weaker won makes Korean products cheaper for foreign buyers, so orders can pick up again. The market ends up helping to correct trade imbalances. That said, it takes time for this effect to show up, and it can be masked by other forces such as capital flows.
Free Policy and Uncertainty Go Together
The biggest advantage of a floating exchange rate system is that the central bank can focus only on the domestic economy when it sets monetary policy. It doesn't have to tie the exchange rate to a particular number, so it can boldly cut interest rates when the economy slows and raise them when prices surge. Also, the need to artificially defend the rate by recklessly pouring out foreign exchange reserves, the nation's vault, shrinks a lot.
But behind freedom, the risk of uncertainty is always hiding. Because the exchange rate changes by the minute like the weather, companies that import and export are always exposed to exchange rate risk. It's hard to know exactly what the rate will be next month, so long-term investment plans and supply contracts get tricky to set up. On top of that, if speculative money from around the world rushes out quickly, the exchange rate can swing wildly in a short time, which creates anxiety.
To Be a Bit More Precise: There Is No Total Hands-Off
To be a bit more precise, almost no country today uses a purely floating system that is left 100% to the market. Even countries with a floating system usually keep room for the government to step in when the exchange rate moves too sharply. Many countries, like Korea, step in when needed, while others, like the United States and the eurozone, intervene only very rarely.
That's because if the exchange rate suddenly spikes or crashes out of control, import prices can soar and healthy exporters can take a big hit. So central banks such as the Bank of Korea normally respect the market's autonomy. But when fear spreads in the market and the rate swings wildly, they buy or sell dollars directly to control the speed of the move. In other words, they let the rate flow freely on the surface while also running a safety net that works only in times of danger.
Common misconceptions
In a country with a floating exchange rate system, the government and the central bank never touch the exchange rate at all.
They basically leave it to the market. But when speculators or an economic crisis send the rate up or down abnormally fast in a short time, the government makes fine adjustments (foreign exchange market intervention) to keep the market stable.
Where you meet it
When the U.S. Federal Reserve sharply raises its benchmark interest rate, demand for dollars surges worldwide, and the won-dollar exchange rate climbs steeply.
When Korean companies' strong exports bring in more dollars, market forces push the won's value up and the exchange rate gradually falls.
In one sentence
It's a system that leaves the exchange rate, the price of a currency, to market supply and demand, so it finds its own balance.