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ADVANTAGES AND

DISADVANTAGES OF
FLOATING EXCHANGE
RATES
Floating exchange rates have these main advantages:

No need for international management of exchange


rates: Unlike fixed exchange rates based on a metallic standard,
floating exchange rates dont require an international manager
such as the International Monetary Fund to look over current
account imbalances. Under the floating system, if a country has
large current account deficits, its currency depreciates.

No need for frequent central bank intervention: Central banks


frequently must intervene in foreign exchange markets under the
fixed exchange rate regime to protect the gold parity, but such is
not the case under the floating regime. Here theres no parity to
uphold.

No need for elaborate capital flow restrictions: It is difficult to


keep the parity intact in a fixed exchange rate regime while
portfolio flows are moving in and out of the country. In a floating
exchange rate regime, the macroeconomic fundamentals of
countries affect the exchange rate in international markets,
which, in turn, affect portfolio flows between countries.
Therefore, floating exchange rate regimes enhance market
efficiency.

Greater insulation from other countries economic


problems: Under a fixed exchange rate regime, countries export
their macroeconomic problems to other countries. Suppose that
the inflation rate in the U.S. is rising relative to that of the Euro-
zone.

Under a fixed exchange rate regime, this scenario leads to an


increased U.S. demand for European goods, which then
increases the Euro-zones price level. Under a floating exchange
rate system, however, countries are more insulated from other
countries macroeconomic problems. A rising U.S. inflation
instead depreciates the dollar, curbing the U.S. demand for
European goods.

Floating exchange rates also have disadvantages:

Higher volatility: Floating exchange rates are highly volatile.


Additionally, macroeconomic fundamentals cant explain
especially short-run volatility in floating exchange rates.

Use of scarce resources to predict exchange rates: Higher


volatility in exchange rates increases the exchange rate risk that
financial market participants face. Therefore, they allocate
substantial resources to predict the changes in the exchange
rate, in an effort to manage their exposure to exchange rate risk.

Tendency to worsen existing problems: Floating exchange


rates may aggravate existing problems in the economy. If the
country is already experiencing economic problems such as
higher inflation or unemployment, floating exchange rates may
make the situation worse.

For example, if the country suffers from higher inflation,


depreciation of its currency may drive the inflation rate higher
because of increased demand for its goods; however, the
countrys current account may also worsen because of more
expensive imports.