Advantages and Disadvantages of Freely Floating Exchange Rates.pdf

Advantages and Disadvantages of Freely Floating Exchange Rates

The freely floating currency system is the predominant system of foreign exchange that is

prevalent in the world today. As globalization has progressed, more countries have abandoned

their currency pegs and have allowed their currencies to freely float. Some have been forced to

do so by market participants whereas others have made their choice in the light of the advantages

that this system has to offer.

In this article, we will have a look at the advantages and disadvantages that are faced by

any country when it adopts a floating exchange rate regime.

Advantages

boards to manage the currency actively on a daily basis. In case of a floating exchange

rate, the central bank does not have to take so many efforts. Instead, it can just passively

manage the currency by setting important rates and interfering in the market only when it

becomes necessary.

 Independence: Freely floating exchange rates allow the governments and central banks

of a nation to have a great degree of independence. In case of fixed exchange rates, the

Central banks of different nations have to act in tandem. This is because the monetary

policy that they set could influence or be influenced by the economic conditions of

member nations. For instance, when the dollar raises its interest rates, all currencies

pegged to it also have to make necessary changes. Hence, the countries that have their

The point is that speculative attacks happen only when the currency remains stagnant at a

given point whereas its underlying fundamentals have changed. It is then that the

speculators see an opportunity to bring the currency to its equilibrium point quickly and

make a quick buck by doing so.

However, if the currency is traded on the Forex market as a freely floating currency,

adjustments happen on a minute to minute basis. Therefore, the gap between the

underlying fundamentals and the market value never really widens up enough for the

speculators to mount a sudden attack.

 Low Requirement of Reserves: A freely floating exchange system does not require the

central bank to hold massive reserves. This is because the Central Bank does not have to

conduct active trading operations in order to maintain the value of the currency. Central

Bank operations are a very rare event for countries that have a floating rate system. This

is a major advantage of this system since holding foreign exchange for trading purposes

is an expensive strategy. Firstly, it requires the country to maintain a huge currency

reserve. Then, it also requires the central bank to have an active trading desk 24 by7! The

floating rate system is simply a lot more convenient since it does not have any such

run, traders find it difficult to engage in foreign trade since they are not aware of the

exact prices that their goods will fetch them. Movements in the currency market can

cause a significant dent in the profits of companies which indulge in foreign trade.

However, these risks can be managed with tools like hedging.

 Allocation of Resources: At a macro level, the economy faces a problem while

allocating resources. This is because as exchange rates change so does the benefit that

can be derived from resources. For instance, a rising exchange rate makes imports a

better option whereas a falling rate makes exports easier. Hence, if exchange rate keeps

of fluctuating, the country cannot really create a long term strategy and stick to it. The

allocation of resources is optimized in the short run. However, in the long run, this

allocation seems to be ad-hoc since it does not follow any given plan.

 Lack of Discipline: Lastly, freely floating exchange rates only make sense if the country

has sufficient internal control mechanisms in place. Hence, if there is likelihood that the

monetary policy may be misused for personal gains by a group of influential people, then

it is better to peg the currency to another more developed currency. In this way, fiscal

It is for this reason that a lot of third world countries prefer to peg their monetary policy

to major currencies like the dollar or the euro.

Therefore, the advantages of fixed rate system are the disadvantages of the floating rate system

The fixed exchange rate is the official rate set by the monetary authorities for one or more

currency. In fact, fluctuation can be observed between upper and lower volatility patterns, which

ultimately leads to the central bank's intervention to stabilize the exchange rate.

The major principal or raw material from which countries are obligated under this system to

directly determine the value of the local currency (such as gold, in most cases), leads to the

stability of the exchange rate.

A fixed exchange rate means that you will always get the same value for your money in the base

currency, and will be given the same exchange rate every time.

Having a fixed exchange rate can give the currency a kind of stability and make financial

transactions more consistent and manageable. However, this means that your currency is affected

by the value of the currency it is fixed (pegged) to, whether it is rising or falling.

In some cases, the government decides on a monetary policy that divides the risk of changing the

value between multiple currencies in different proportions - between two or more currencies.

To float a currency is to make the exchange rate of this currency fully liberalized, so that the

government or the central bank does not interfere in setting it directly. Rather, it is automatically

emptied into the currency market through a supply and demand mechanism that allows setting

the national currency's exchange rate against foreign currencies.

Floating currency exchange rates fluctuate constantly with every change in the supply and

demand of foreign currencies, so that they can change even several times per day.

The supply and demand for a currency is affected by a number of factors, including but not

limited to:

 Global trade

 Interest rates

 Foreign and international investment

Any or all of these factors will have a significant impact on the value of a currency in the

international forex market. For example, in a country with a lot of foreign commercial

investment, the demand for the local currency will increase, and this will lead to an increase in