Floating Exchange rates

Question 1

1) What are the advantages of a floating exchange rate?

Answer 1

1. Automatic Stabilisation:

Any disequilibrium in the balance of pay­ments would be automatically corrected by a change in the exchange rate. For example, if a country suffers from a deficit in the balance of payments (i.e. we import more than we export) then, other things being equal, the country’s currency should depreciate.

This would make the country’s exports cheaper, thus increasing demand (and competitiveness), while at the same time making imports expensive and decreasing demand. And vice versa.

Question 2

2) What are the advantages of a floating exchange rate?

Answer 2

2)Freeing Internal Policy:

Under the floating exchange rate system the balance of payments deficit of a country can be rectified by changing the external price of the currency. On the countrary if a fixed exchange rate policy is adopted, then reducing a deficit could involve a general deflationary policy for the whole economy, resulting in unpleasant consequences such as unemployment and idle capacity.

Thus, a floating exchange rate allows a government to pursue internal policy objectives such as full employment growth in the absence of demand-pull inflation without external con­straints (such as debt burden or shortage of foreign exchange)

Question 3

3) What are the advantages of a floating exchange rate?

Answer 3

3) Lower reserves:

floating exchange rates should mean that there is hardly any need to maintain large reserves to develop the economy. These reserves can therefore be fruitfully used to import capital goods and other items in order to promote faster economic growth.

Question 4

What are the disadvantages of a floating exchange rate?

Answer 4

1. Uncertainty:

The very fact that currencies change in value from day to day introduces a large element of uncertainty into trade. A seller may not be quite sure of how much money he will receive when he sells goods abroad. Some of this uncertainty may be reduced by companies buying currency ahead in forward exchange contracts.

2. Lack of Investment:

The uncertainty introduced by floating exchange rates may discourage direct foreign investment (i.e., investment by multi­national companies).

3. Speculation:

The day-to-day fluctuations in exchange rates may en­courage speculative movements of ‘hot money’ from country to country, thereby cause more and mooring exchange rate fluctuations