A floating exchange rate or fluctuating exchange rate is

a type of exchange rate regime wherein a currency's value is allowed

to fluctuate according to the foreign exchange 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 rate of exchange for its currency in the exchange market.
There are two options open for them- [1] Let the 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 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 and foreign business 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. The debate of making a choice
between fixed and floating exchange rate regimes is set forth by the
Mundell-Fleming model, which argues that an economy cannot
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:

 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 intervention in the foreign exchange market.

The number of countries that present fear of floating increased

significantly during the nineties.

The advantages and disadvantages of floating

exchange rates
Advantages
 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.

FLOATING
EXCHANGE
RATES

BY

SYED MURTUZA ALI

SUB: FOREX MANG.

IIPM – EXE – MBA – (09-10)

(ASSIGNMENT)