What is the free market exchange rate system?

In the realm of economics, exchange rate systems play a pivotal role in determining the value of currencies relative to each other. One such system is the free-floating exchange rate system, where the market forces of demand and supply solely dictate the exchange rates.

In this system, the interaction between buyers and sellers of different currencies in the foreign exchange market establishes the exchange rate. An increase in demand for a particular currency, for instance, would lead to its appreciation against other currencies, while a decrease in demand would result in depreciation.

Conversely, the managed float system also relies on demand and supply to determine exchange rates. However, in this system, governments actively intervene in the market by buying or selling currencies to influence the exchange rate in a desired direction.

Governments may intervene to prevent sharp fluctuations in exchange rates that could harm their economies, such as impacting exports or imports. By buying or selling currencies, they can add or remove supply from the market, thereby influencing the exchange rate.

The extent of government intervention varies across countries and depends on their economic policies and objectives. Some governments may intervene more frequently to maintain stability, while others may allow the market to determine exchange rates with minimal interference.