Floating Exchange Rate

 

A floating exchange rate or fluctuating exchange rate is 's value is allowed a type of exchange of exchange rate regime wherein a currency 's to fluctuate according to the foreign exchange market. market. A currency  that uses a floating exchange rate is known as a floating currency . It is not possible for a developing country to maintain the stability  in the are ratetwo of exchange for its thethe exchange market.  There options open forcurrency them- [1]inLet exchange rate be allowed to fluctuate in the open market according to the market conditions, or [2] An equilibrium rate may be fixed to be adopted and attempts should be made to maintain it as far fa r as possible. But, if there is a fundamental change in the circumstances, the rate should be changed accordingly. The rate of exchange under the first alternative is know as fluctuating rate of exchange and under second alternative, it is called flexible rate of exchange. In the modern economic conditions, the flexible rate of exchange system is more appropriate as it does not hamper the foreign trade. There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks of shocks and foreign business cycles, cycles, and to preempt the possibility of having a balance of payments crisis. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. crisis. The debate of making a choice between fixed and floating exchange rate regimes is set forth by the model, which argues that an economy cannot Mundell-Fleming model, simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any  two for control, and leave third to the market forces. In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may 

 

take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds. Fear

of floating

A free floating exchange rate increases foreign exchange volatility.  There are economists who think that this could cause serious problems, especially in emerging economies. These economies have a financial sector with one or more of following conditions:  

y

 

y

 

y

high liability dollarization financial fragility  strong balance sheet effects

When liabilities are denominated in foreign currencies while assets are in the local currency, unexpected depreciations of the exchange rate deteriorate bank and corporate balance sheets and threaten the stability of the domestic financial system. For this reason emerging countries appear to face greater fear of  floating, as they have much smaller variations of the nominal exchange rate, yet face bigger shocks and interest rate and reserve movements.[1] This is the consequence of frequent free floating countries' reaction to exchange rate movements with monetary  policy and/or and/or intervention in the foreign exchange market market.. policy   The number of countries that present fear of floating increased significantly during the nineties. The

advantages and disadvantages of floating exchange rates

 

Advantages  

y

balance of payments adjustment - Any balance of payments disequilibrium will tend to be rectified by a change in the exchange rate. For example, if a country has a Automatic

balance of payments deficit imports then thewill currency should depreciate. This is because be greater than exports meaning the supply of sterling on the foreign exchanges will be increasing as importers sell pounds to pay  for the imports. This will drive the value of the pound down.  The effect of the depreciation should be to make your exports cheaper and imports more expensive, thus increasing demand for your goods abroad and reducing demand for foreign goods in your own country, therefore dealing with the balance of  payments problem. Conversely, a balance of payments surplus should be eliminated by an appreciation of the currency. y

 

 

y

 

y

 

y

internal policy - With a floating exchange rate, balance of payments disequilibrium should be rectified by a change in the external price of the currency. However, with a fixed rate, curing a deficit could involve a general deflationary  policy resulting in unpleasant consequences for the whole economy such as unemployment. The floating rate allows governments freedom to pursue their own internal policy  objectives such as growth and full employment without external constraints. Absence of crises - Fixed rates are often characterised by  crises as pressure mounts on a currency to devalue or revalue.  The fact that, with a floating rate, such s uch changes are automatic should remove the element of crisis from international relations. Flexibility - Post-1973 there were great changes in the pattern of world trade as well as a major change in world economics as a result of the OPEC oil shock. A fixed exchange rate would have caused major problems at this time as some countries would be uncompetitive given their inflation rate.  The floating rate allows a country to re-adjust more flexibly to external shocks. ower foreign exchange reserves - A country with a fixed L ower rate usually has to hold large amounts of foreign currency in Freeing

 

order to prepare for a time when they have to defend that fixed rate. These reserves have an opportunity cost. Disadvantages

 

y

 

y

 

y

 

y

 

y

 

y

of the

Uncertainty

Floating

Rate

- The fact that a currency changes in value from

day to day introduces instability or uncertainty into trade. Sellers may be unsure of how much money they will receive when they sell abroad or what their price actually is abroad. Of course the rate changing will affect price and thus sales. In a similar way importers never know how much it is going to cost them to import a given amount of foreign goods. This uncertainty can be reduced by hedging the foreign exchange risk on the forward market. L ack ack of investment - The uncertainty can lead to a lack of  investment internally as well as from abroad. Speculation - Speculation will tend to be an inherent part of a floating system and it can be damaging and destabilising for the economy, as the speculative flows may often differ from the underlying pattern of trade flows. L ack ack of discipline in economic management - As inflation is not punished there is a danger that governments will follow inflationary economic policies that then lead to a level of  inflation that can cause problems for the economy. The presence of an inflation target should help overcome this. Does a floating rate a utomatically remedy a deficit? - UK experience indicates that a floating f loating exchange rate probably  does automatically cure elasticity a balanceofofdemand payments Muchnot depends on the price for deficit. imports and exports. The Marshall-Lerner condition says that a depreciation in the exchange rate will help improve the balance of payments if the sum of the price elasticities for imports and exports is greater than one. Inflation - The floating exchange rate can be inflationary. Apart from not punishing inflationary economies, which, in itself, encourages inflation, the float can cause inflation by  allowing import prices to rise as the exchange rate falls. This is, undoubtedly, the case for countries such as UK where we are dependent on imports of food and raw materials.

 

 

FLOATING EXCHANGE RATES

 

  BY SYED MURTUZA ALI SUB: FOREX MANG. IIPM ± EXE ± MBA ± (09-10) (ASSIGNMENT)