Question

Present the case for and the case against a system of floating exchange rates.

Short answer

A system of floating exchange rates has its advantages and disadvantages. On the positive side, it reflects real market value, adjusts automatically to trade disorders, and allows domestic policy freedom. However, it may cause exchange rate volatility, unfavourable trade and investment impacts, and possible 'currency wars' due to excessive competitive devaluation.

Step-by-step solution

Understanding the Concept of Floating Exchange Rates

Floating exchange rates refers to a regime where the currency price is set by the forex market on the basis of supply and demand as compared with other currencies. This is in contrast to a fixed exchange rate, where the government entirely or predominantly determines the rate.

The Case For Floating Exchange Rates

1. Market-Determined Rates: In floating exchange rate systems, currency rates are determined by market forces and therefore are most likely to reflect the actual value of the currency based on current economic conditions. 2. Automatic Adjustment: Floating exchange rates can help rectify trade imbalances. If a country's goods are too expensive due to high prices for its currency, the fall in demand can lead to depreciation of the currency and the prices becoming more competitive, thus rebalancing trade. 3. Independence over Domestic Policy: It allows a country to maintain full control over its domestic monetary policy, without having to maintain exchange rates within specified limits or sacrifice goals for unemployment or inflation.

The Case Against Floating Exchange Rates

1. Exchange Rate Volatility: Floating exchange rates can be highly volatile leading to economic uncertainty. Frequent fluctuations in exchange rates can create instability in the global economy. 2. Trade and Investment Impact: Unpredictable exchange rates can negatively impact foreign trade and investment, as companies struggle to hedge against sudden exchange rate shifts that could negatively impact profits. 3. Threat of 'Currency Wars': Under a floating system, there's a risk of competitive devaluations which could lead to a 'currency war'. Countries may competitively devalue their currencies to secure an advantage in global trade which could lead to economic instability or crisis.

Key concepts

Exchange Rate Volatility

Exchange rate volatility refers to fluctuations or changes in the value of a currency relative to others. In a floating exchange rate system, these changes are driven by market forces of supply and demand.
It's like a roller-coaster ride; currency values can go up and down frequently. This volatility can introduce uncertainty in economic planning for businesses and governments. For instance, if a country's currency suddenly appreciates, its exports might become more expensive, impacting the revenues of companies that rely heavily on foreign sales.
- **Impact on Business Plans**: Volatile exchange rates can disrupt business forecasts and strategies. - **Ingredient of Economic Uncertainty**: Economies may find it challenging to plan for long-term growth when exchange rates are unpredictable. - **Complications in Trade**: Volatility makes it tougher for businesses to price their goods or services uniformly in international markets.
While a dynamic system, exchange rate volatility requires careful management measures, such as using financial instruments like futures and options to hedge against unpredictable changes.

Market-Determined Rates

Market-determined rates are based on the natural market forces of supply and demand without direct governmental intervention. This means currencies can find their true value reflective of the economic realities.
In theory, this supports efficient markets where prices adjust to reflect all available information. The adjustment happens naturally as investors and traders buy or sell currencies based on their expectations of a country's economic future.
- **Reflective of Economic Health**: A strong currency typically indicates a healthy and robust economy. - **Continuous Price Discovery**: Markets assess a country's economic indicators, such as interest rates and inflation, to determine the currency's value. - **Responsive and Adaptive**: The exchange rates can quickly respond to changes in the economic environment, helping to avoid prolonged trade imbalances.
Although market-determined rates bring transparency, they also imply susceptibility to speculation, which can amplify exchange rate volatility.

Economic Adjustment Mechanisms

Economic adjustment mechanisms are processes that naturally correct imbalances in an economy, often facilitated by floating exchange rates. These mechanisms allow for automatic correction of large trade deficits or surpluses.
Think of them as nature's way of finding balance. When a currency's value drops, a country's goods become cheaper for foreign buyers, potentially increasing exports and correcting trade imbalances.
- **Trade Balance Improvement**: By making exports cheaper, countries can increase their sales abroad, thus correcting trade deficits. - **Inflationary Pressure Moderation**: Currency depreciation can increase the price of imports, which may reduce excessive consumption. - **Encouragement of Domestic Industries**: With pricier imports, domestic goods become more attractive, boosting local industries.
Thus, economic adjustment mechanisms enable a nation to stabilize its economy autonomously without the need for government interference or drastic policy changes. This self-correcting nature is a key advantage of the floating rate system.