Advantages and disadvantages of freely floating exchange rates

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  • Created by: icebat
  • Created on: 26-04-17 19:56

Advantages and disadvantages of freely floating exchange rates

Advantages

  • Do not have to hold significant foreign currency reserves
  • Central bank is free to pursue domestic monetary policy i.e. control interest rates
  • Can act as automatic stabilisers; i.e. during a recession, value of currency may fall and lead to more exports
  • May insulate economy from imported inflation: if inflation is higher in other countries, demand for UK exports may rise, leading to an appreciation of the Sterling: making import prices cheaper ; this protects businesses from cost-push inflation

Disadvantages

  • Can be volatile because it is subject to speculation and "hot money" flows. Currency trading by hedge funds, financial institutions etc. represents 90% of transactions
  • May create uncertainty for firms that rely on international trade for exports and imports to manufacture their products
  • If UK has high inflation can lead to a downward spiral. Demand for our imports and therefore currency decreases, leads to cost-push inflation leading to a further increase in inflation and subsequent decrease in the exchange rate
  • Currency can become over/undervalued due to hot money flows - ER does not accurately reflect trading competitiveness

Evaluation

Depending on the government's specific macroeconomic objectives and how developed the economy is, freely floating exchange rates can be a good option. They allow for autonomous monetary policy in terms of controlling interest rates, which is crucial for key objectives such as inflation and growth. However, there are caveats to consider, including the risks of capital flight and international trade stability. In this case, fixed exchange rates may be more appropriate for developing economies. 

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