Advantages and Disadvantages of Freely Floating Exchange Rates

The freely floating currency system is the predominant system of foreign exchange that is prevalent in the world today. As globalization has progressed, more countries have abandoned their currency pegs and have allowed their currencies to freely float. Some have been forced to do so by market participants whereas others have made their choice in the light of the advantages that this system has to offer.

In this article, we will have a look at the advantages and disadvantages that are faced by any country when it adopts a floating exchange rate regime.

Advantages

• Market Determined Rates: Freely floating exchange rate means that the market will determine the rate at which one currency can be exchanged for another. The market will set these rates on a real time basis as and when new information flows in. This reduces the need for an elaborate mechanism to ensure that the exchange rates remain within a particular range.

  Fixed exchange rates require the Central Banks to set up trading desks and currency boards to manage the currency actively on a daily basis. In case of a floating exchange rate, the central bank does not have to take so many efforts. Instead, it can just passively manage the currency by setting important rates and interfering in the market only when it becomes necessary.

• Independence: Freely floating exchange rates allow the governments and central banks of a nation to have a great degree of independence. In case of fixed exchange rates, the Central banks of different nations have to act in tandem. This is because the monetary policy that they set could influence or be influenced by the economic conditions of member nations.

  For instance, when the dollar raises its interest rates, all currencies pegged to it also have to make necessary changes. Hence, the countries that have their currencies pegged to the dollar have limited independence whereas countries that let their currencies float have a far greater degree of independence.

• Less Probability of Speculative Attacks: A freely floating currency faces adjustment on a minute to minute basis. There are some days that the currency faces rapid appreciation whereas others when it faces rapid decline. However, for most of the days, the currency remains stable.

  The point is that speculative attacks happen only when the currency remains stagnant at a given point whereas its underlying fundamentals have changed. It is then that the speculators see an opportunity to bring the currency to its equilibrium point quickly and make a quick buck by doing so.

  However, if the currency is traded on the Forex market as a freely floating currency, adjustments happen on a minute to minute basis. Therefore, the gap between the underlying fundamentals and the market value never really widens up enough for the speculators to mount a sudden attack.

• Low Requirement of Reserves: A freely floating exchange system does not require the central bank to hold massive reserves. This is because the Central Bank does not have to conduct active trading operations in order to maintain the value of the currency.

  Central Bank operations are a very rare event for countries that have a floating rate system. This is a major advantage of this system since holding foreign exchange for trading purposes is an expensive strategy.

  Firstly, it requires the country to maintain a huge currency reserve. Then, it also requires the central bank to have an active trading desk 24 by7! The floating rate system is simply a lot more convenient since it does not have any such requirements.

Disadvantages

The freely floating currency system also has its critics. They suggest that the system has a few serious flaws. Some of the important ones have been listed below:

• Uncertainty: Firstly, a freely floating currency rate implies a lot of volatility. The value of currencies change on a real time basis. Also, since Forex market is not regulated, currency values could skyrocket or hit rock bottom in a matter of minutes.

  In the short run, traders find it difficult to engage in foreign trade since they are not aware of the exact prices that their goods will fetch them. Movements in the currency market can cause a significant dent in the profits of companies which indulge in foreign trade. However, these risks can be managed with tools like hedging.

• Allocation of Resources: At a macro level, the economy faces a problem while allocating resources. This is because as exchange rates change so does the benefit that can be derived from resources.

  For instance, a rising exchange rate makes imports a better option whereas a falling rate makes exports easier. Hence, if exchange rate keeps of fluctuating, the country cannot really create a long term strategy and stick to it. The allocation of resources is optimized in the short run. However, in the long run, this allocation seems to be ad-hoc since it does not follow any given plan.

• Lack of Discipline: Lastly, freely floating exchange rates only make sense if the country has sufficient internal control mechanisms in place. Hence, if there is likelihood that the monetary policy may be misused for personal gains by a group of influential people, then it is better to peg the currency to another more developed currency. In this way, fiscal discipline is imposed on the economy. Freely floating currencies provide independence. However, the independence can only be utilized if the economy is disciplined enough.

  It is for this reason that a lot of third world countries prefer to peg their monetary policy to major currencies like the dollar or the euro.

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. There are no right or wrong answers. Rather the appropriate choice depends on how the country views the Forex markets and what its long term objectives are.