Question

Explain the benefits and costs of having a floating exchange rate system. Give examples of each point.

Answer 1

Advantages

• As per Impossible trinity in economics, it is impossible to have a fixed exchange rate, free capital movement and an independend monetary policy together. Hence making the exchange rate floating, we can control free capital movement and independend monetary policy in a country.
• Floating exchange rate will give flexibility and protection from external shocks. ie: Sudden huge change in Petrol price or other commodity wont affect a country significantly.
• Free from policy constraints- the governement has full freedom to implement the policy in the country without depending on international signal.
• Balance of payments correction- a floating exchange rate can adjust of Balance of payment deficit.

eg: In HongKong, the currency is pegged with USD and because of this they have to follow the same monetary policy changes as USA and dont have freedom to implement their own monetary policy as they desire.

Disadvantages:

• The exhange rate is highly affected by speculation that give unrealistic rates. Suppose if there are news about war in a country the value of the currency tend to go down significantly as people start to invest in other currencies.
• Instability - For firms that depend on international trades, due to volatility in rates, their profit are affected significantly.
• Tendency to worsen the existing problems as market will be unfavourable for such currencies.
• Need of scare resources to onitor the exchange rates. The country need to continously monitor the rates and try to adjust the rates through market operations.

eg: Countries like India which follows floating rate has a dollar dependency with USD and due to which continous monitoring to stabilize the rate needs to be done for a less volatile international trade environment,