Advantages and disadvantages of floating exchange rates - Further work - Foreign exchange market - Markets - Economics bank - Virtual Bank of Biz/ed

Markets - Foreign exchange market

Further work - The advantages and disadvantages of floating exchange rates

Arguments in Favour of a Floating Exchange Rate

  • Automatic 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 balance of payments deficit then the currency should depreciate. This is because imports will 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.
  • Freeing 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 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.
  • Lower foreign exchange reserves - A country with a fixed rate usually has to hold large amounts of foreign currency in order to prepare for a time when they have to defend that fixed rate. These reserves have an opportunity cost.

Disadvantages of the Floating Rate

  • Uncertainty - 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.
  • Lack 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.
  • Lack 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 automatically remedy a deficit? - UK experience indicates that a floating exchange rate probably does not automatically cure a balance of payments deficit. Much depends on the price elasticity of demand for 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.