Pros + Cons Floating Exchange Rate Flashcards
Advantages of a floating exchange rate system
Fluctuations in the exchange rate can provide a partial automatic adjustment for countries with a large current account deficit.
- If an economy has a large deficit, there is a net outflow of currency from the country.
- This puts downward pressure on the exchange rate and if a depreciation occurs, the relative price of exports in overseas markets falls (making exports more competitive) whilst the relative price of imports in the home markets goes up (making imports appear more expensive).
- This should help reduce the overall deficit in the balance of trade provided that the price elasticity of demand for exports and the price elasticity of demand for imports is sufficiently high.
There is less need for the central bank/government to keep foreign reserves in a central bank for the purpose of manipulating the exchange rates.
May help to prevent imported inflation.
The government can pursue policies such as interest rate changes without fear that it will be putting the exchange rate under pressure i.e. independent monetary policy.
Less risk of speculative attack as there is less risk of the currency becoming significantly over/undervalued.
Insulation for an economy after an external shock, especially for export-dependent countries.
Fixed exchange rates may conflict with other macroeconomic objectives.
Disadvantages of the floating exchange rate system:
Higher volatility: Floating exchange rates can be highly volatile. Additionally, macroeconomic fundamentals can’t explain especially short-run volatility in floating exchange rates.
Potential lack of investment: The uncertainty can lead to a lack of investment internally as well as from abroad.
Does a floating rate automatically remedy a deficit? UK experience indicates that a floating exchange rate does not automatically cure a current account deficit on BoP. Much depends on the price elasticity of demand for imports and exports. The Marshall-Lerner condition says that depreciation in the exchange rate will help improve the balance of trade if the sum of PEDX + PEDM > 1.
Inflation: If a country has inflation which makes its goods uncompetitive, this will lead to a fall in the demand for the currency and the exchange rate will depreciate. This makes the domestic goods become more competitive (i.e. restore competitiveness), but makes imports more expensive (cost-push inflation). This is, undoubtedly, the case for countries such as UK where we are dependent on imports of food and raw materials.
Speculation/hot money: Hot money flows (e.g. £ depreciation against the € and $ post-EU referendum vote) will tend to be an inherent part of a floating exchange rate system and it can be damaging and destabilising for the economy, as the speculative flows may differ from economic fundamentals.
