Question

Explain how exchange rates are determined under a floating exchange rate system. Then, thoroughly discuss the advantages and disadvantages of each system.

Answer 1

Answer) A floating exchange rate is a game where the currency price of a nation is set by the forex market established on supply and demand relative to other currencies. This is a difference to a fixed exchange rate, in which the government entirely or predominantly determines the rate.

Advantages of floating exchange rates

Protection from external shocks - if the exchange rate is free to float, then it can change in reaction to external shocks like oil price rises. This should curtail the negative effect of any exterior impacts.

Lack of policy constraints - the government are free with a floating exchange rate system to maintain the policies they feel are reasonable for the domestic economy without bothering about them differing with their external policy.

Correction of the balance of payments deficits - a floating exchange rate can depreciate to offset for a balance of payments deficit. This will help restore the competitiveness of exports.

Disadvantages of floating exchange rates

Instability - floating exchange rates can be prone to vast variations in value and this can result in uncertainty for firms. Investment and trade may be adversely influenced.

No constraints on domestic policy - governments may be free to pursue incompatible domestic policies (e.g. excessively expansionary policies) as the exchange rate will not act as a restriction.

Speculation - the existence of speculation can lead to exchange rate differences that are irrelevant to the basic pattern of trade. This will also cause instability and uncertainty for firms and consumers.