Floating Exchange Rate Overview, Functions, Benefits, Limitations

In December 1971, the INR was directly linked to the Pound Sterling. If these bodies do not step in, there is bound to be an ‘economic shock’ to the country. As you know, India is a developing country with precise economic requirements. The GDP has been growing at a steady pace, and INR’s strength has increased over the last couple of years.

advantages of floating exchange rate

Exchange rates can be fixed or floating and this article will tackle the latter including its pros and cons. A floating exchange rate is determined by the private market based on supply and demand whereas the fixed rate is decided by the central bank. Hence, the reserves can be utilized for promoting economic growth by importing capital goods. Under flexible exchange rate regime, the rate of exchange is determined by the forces of demand and supply.

This ensures an appropriate money supply, appropriate fluctuations in the market (inflation/deflation), and ultimately, the exchange rate. The conditions may even get worse because of expensive imports. A rapid appreciation in the exchange rate will badly affect manufacturing firms who export; this may also cause a worsening of the current account. A fixed exchange rate, by contrast, means firms have an incentive to keep cutting costs to remain competitive. Political factors that can cause a change in the foreign exchange rate are political unrest or instability in the country and any kind of political conflict. In other words, to keep the exchange rate fixed, the Indonesian central bank must keep its interest rate spread, with the interest rates in the United States unchanged.

To ensure fair competition and maintain adequate BoP, a managed floating exchange rate is necessary. The then-Government finally decided to let market forces decide exchange rates. A transition system – termed Liberalised Exchange Rate Management System or LERMS, was set in place. In India, the exchange rate regimen is governed by the Reserve Bank of India , often called the ‘Banker of Banks’. There are several types of exchange rate regimes, including managed float, free float, and a flexible exchange rate. The economy may be unable to respond to shocks – a fixed exchange rate means that there may be no mechanism for the government to respond rapidly to balance of payments crises.

But, if the movement became unfavorable, the government intervenes in the market. Such intervention is to avoid sharp fluctuations in the exchange rate, so it supports economic stability. Absence of speculation – with a Spectre.ai Forex Broker Review fixed exchange rate, there will be no speculation if people believe that the rate will stay fixed with no revaluation or devaluation. The answer depends on the country’s macroeconomic situation and currency strength.

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Furthermore, the short-term volatility in a floating exchange rate cannot be explained through macroeconomic fundamentals. In this article we will discuss about the advantages and disadvantages of floating exchange rates. Policy Trilemma – why fixed exchange rates are one out of possible three targets of Spectre.ai Forex Broker Review monetary policy. In these two short revision videos, we explore the relative advantages and drawbacks of floating and fixed exchange rates. A floating exchange rate is a fiscal policy adopted by certain countries where their currency’s value is allowed to fluctuate in line with prevailing market forces.

  • Forces, which is crucial for the currency’s strength and attracting additional investors.
  • A fixed exchange rate occurs when a country keeps the value of its currency at a certain level against another currency.
  • The countries using managed floating exchange rates are India, South Africa, Japan, Mexico, and Israel.
  • A managed floating exchange prevents such practices and ensures balance.
  • Say the US central bank lowers interest rates to stimulate growth.

When the external value of a domestic currency increases because of the different market forces of demand and supply, it causes what is known as an appreciation. It means that the value of a given currency is more than the value of another foreign currency. The lack of control over floating exchange rates can limit economic growth or recovery. The negative currency exchange rate movements may lead to serious issues. For example, if the dollar rises against the euro, it will be more difficult to export to the eurozone from the U.S.

A floating exchange rate functions in an open market where speculations, along with demand and supply forces, drive the price. Floating exchange rate structures mean that changes in long-term currency prices represent comparative economic strength and differences in interest rates across countries. Changes in the short-term floating exchange rate represent disasters, speculations, and the daily supply and demand of the currency. Pure floating exchange rates contrast with fixed exchange rates. Under the latter system, the exchange rate is pegged at a certain level and does not move.

Floating Exchange Rates: Advantages and Disadvantages | Currencies

Such a situation weakens the domestic currency’s price against the trading partner’s currency . This would make the country’s exports cheaper, thus increasing demand, while at the same time making imports expensive and decreasing demand. In this context, the term ‘market forces’ means the forces of supply and demand. We also call it a fluctuating exchange rate or flexible exchange rate. A fixed exchange rate is a system in which the government attempts to maintain the value of its currency. A floating exchange rate is a regime where the currency price of a nation is set by the forex market based on supply and demand relative to other currencies.

In this case, we assume the constant elasticity of demand for exported and imported goods. If demand elasticity is at work, the effects of depreciation on exports and imports would not be as easy as the above. If you are searching for high-frequency daily trading, make sure there are various trading styles allowed. Therefore, the advantages of fixed rate system are the disadvantages of the floating rate system and vice versa. The choice between these two systems is therefore an ideological choice. Rather the appropriate choice depends on how the country views the Forex markets and what its long term objectives are.

A fixed exchange rate has been proven to create global trade as well as provide monetary stability. So even if a floating exchange rate has its set of flaws, it is more efficient in being able to determine the value of a currency as well as creating equilibrium in the international market. Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for European goods, which then brokerage house meaning increases the Euro-zones price level. Under a floating exchange rate system, however, countries are more insulated from other countries macroeconomic problems.

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However, Indonesia’s central bank would intervene in the market because Indonesia adopts a fixed exchange rate. The value of an exchange rate in a floating system is determined by the demand for, and supply Who is Maxitrade Broker – Visual inspection and review of, a currency. In a freely floating exchange rate system, the forces of demand and supply cause the exchange rate to settle at the point where the quantity of a currency demanded equals quantity supplied.

advantages of floating exchange rate

It does this to gain back the confidence of big businesses and important investors, which might weaken because of great fluctuations in the market forces. For example, in the above case, if the Indonesian central bank increases the money supply, it would push up the domestic inflation rate. If domestic inflation is still high at that time, such a policy would only increase the upward inflation pressure and could lead to hyperinflation. Domestic consumers demand foreign currency to pay for imported goods. They then sell the domestic currency and exchange it for foreign currency.

Exchange Rates – An Introduction

Monetary Policy Of The CountryMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. The ‘Par Value’ system that governed exchange rates was in place. The Indian Rupee’s external par value was tied to gold reserves.

Under the floating exchange rate system the balance of payments deficit of a country can be rectified by changing the external price of the currency. A fall in the nominal foreign exchange rate lowers the real exchange rate. A fixed exchange rate system exists when there is a hard or semi-fixed currency peg.

Pros and Cons of Floating Exchange Rate

The day-to-day fluctuations in exchange rates may en­courage speculative movements of ‘hot money’ from country to country, thereby cause more and mooring exchange rate fluctuations. If a currency is under pressure and falling – the most effective way to increase the value of a currency is to raise interest rates. This will increase hot money flows and also reduce inflationary pressures. However higher interest rates will cause lower aggregate demand and lower economic growth, If the economy is growing slowly this may cause a recession and rising unemployment. It is hoped a fixed exchange rate will reduce inflationary expectations. Governments who allow their exchange rate to devalue may cause inflationary pressures to occur.

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