How are exchange rates defined in a floating exchange rate system?

In a floating exchange rate system, exchange rates are defined by market supply and demand. This means that the value of a currency is determined by how much of that currency people and businesses are willing to buy and sell relative to other currencies in the open market. When demand for a currency increases—due to factors such as higher interest rates, economic stability, or robust exports—the value of that currency typically appreciates. Conversely, if demand decreases, the currency may depreciate.

This system allows for more flexibility in the exchange rate and can reflect the economic conditions of the countries involved. In contrast to fixed systems, where governments might set exchange rates or peg them to a stable currency or asset, a floating exchange rate lets the currency value fluctuate based on the dynamic interactions of the market participants. Thus, the reliance on market supply and demand captures the true, fluctuating value of a currency based on real-time economic activity.