The value of the local currency, the birr, slid by around 30 percent against the dollar after the announcement of the measures by the central bank.
"The reform introduces a competitive market-based determination of the exchange rate and addresses a long-standing distortion within the Ethiopian economy," the National Bank of Ethiopia (NBE) said in a statement.
Africa's second most populous country is pinning its hopes on a rescue package of around $10.5 billion from external lenders including the International Monetary Fund (IMF), but negotiations have been long and fraught.
Analysts say the IMF has been calling for numerous reforms of Ethiopia's tightly state-controlled economy, including floating the currency, in order to unlock the funding.
The Horn of Africa nation, battered in recent years by several armed conflicts, the Covid pandemic, and climate shocks, has about $28 billion of external debt and is also grappling with sky-high inflation and a shortage of foreign currency reserves.
Under the shift to a market-based exchange rate regime, the NBE said "banks are henceforth allowed to buy and sell foreign currencies from/to their clients and among themselves at freely negotiated rates".
The central bank would, it said, make "only limited interventions to support the market in its early days and if justified by disorderly market conditions".
'Integration with rest of world'
After the announcement, the leading Commercial Bank of Ethiopia said in a statement that the US dollar was buying 74.73 birr and selling at 76.23. This compares to a buying rate on Friday of 57.48 and a selling rate of 58.64.
Ethiopia has a highly active black market for currency trading, with the value of the birr at about 50 percent of the previous official rate.
Until now, the rate for the birr, a non-convertible and non-exportable currency, was set daily by the NBE.
"The FX reforms... represent a comprehensive set of measures that will support Ethiopia's current stage of development and its increasing integration with the rest of the world," the central bank said.
The NBE also foreshadowed the opening of Ethiopia's securities market to foreign investors, saying terms and conditions would be disclosed in the near future.
Among other measures, it said it would allow foreign exchange to be retained by exporters and commercial banks "thus substantially boosting FX supplies to the private sector".
It also announced the introduction of non-bank foreign exchange bureaus that would be allowed to buy and sell foreign currency in cash at market rates.
'Robust growth'
When he took office in 2018, Prime Minister Abiy Ahmed pledged to embark on reforms of Ethiopia's closed and state-dominated economy, but progress has been slow.
In a statement on Sunday, Abiy said Ethiopia's reform agenda "will lay the foundation for strong, private sector-led inclusive economic growth and job creation".
He said the economy had registered "robust" economic growth over the past six years, with an average GDP growth rate of 7.1 percent from fiscal year 2019 to 2023.
But more than 21 million people, or about 18 percent of Ethiopia's population, rely on humanitarian aid as a result of conflict, and climate disasters such as flooding or drought, according to UN figures.
The landlocked country's credit rating was downgraded to a partial default in December by international agency Fitch after it missed a $33 million coupon payment on a Eurobond.
The two-year conflict in the northern Tigray region which ended in November 2022 led to the suspension of numerous development aid programmes and budget assistance.
Reacting to Monday's news, the US embassy said in a statement that a market-based foreign exchange was a "difficult but necessary step for Ethiopia to address macro-economic distortions".
"We encourage the government, with the help of development partners, to implement reforms to support the Ethiopian people and progress towards a more free and robust economy."
