A Floating Exchange Rate Regime - Literature review Example

A FLOATING EXCHANGE RATE REGIME by + Table of Contents A FLOATING EXCHANGE RATE REGIME 3 Introduction 3 Relative Advantages of Operating a Floating Exchange Rate Regime 3 Relative Disadvantages of Operating a Floating Exchange Rate Regime 5 Conclusion 7 References 8 A FLOATING EXCHANGE RATE REGIME Introduction A floating exchange rate regime is the exchange rate regime of a country in which the currency of that particular country is determined by the market in the foreign exchange (Sloman, Wride & Garratt, 2012). This is specifically through demand and supply for that specific currency comparative to the other available currencies. The floating exchange rate regimes are therefore a resolute of the trade carried out in the forex market and it is capable of fluctuating freely. This is unlike the fixed exchange rate regime that does not fluctuate and is not determine by the forex market. In some occasions, if the value of the currency of a particular country constantly moves in one direction at a prompt and unrelenting rate, the central bank of that country may intervene through the purchase and sell of its own currency investments in the foreign exchange market. This is aimed towards stabilizing the local currency in question. It is however notable that the central banks are never willing to intervene in a country’s floating exchange rate regime unless it is unequivocally essential. The following paper is going to give a critical analysis of the relative advantages and disadvantages of operating a floating exchange rate regime with explicit reference to the economy of the U.K over the previous 20 years. Relative Advantages of Operating a Floating Exchange Rate Regime There are many advantages that a country can obtain by operating a floating exchange rate regime. First and foremost, a floating exchange rate regime makes it possible to have an automatic balance of payments adjustment (Krugman, Wells & Graddy, 2008). This means that if there is any balance of payments instability, then it will be remedied by a modification in the exchange rate regime. For instance, if a particular country experiences a balance of payments discrepancy, then the currency of that particular country ought to devalue. This is because the number of exports will be lower while the imports will be greater. With this, the supply of the UK Sterling pound on the foreign exchanges will be aggregating as those who import will be selling the Sterling pounds in order to make payments for the imports. This will make the pound to depreciate in value. The impact of the depreciation in value of the pound is thus to put in place measures ensuring that the imports are very expensive while the exports are kept cheap. This will translate to the demand of the goods from the UK in the foreign market while the demand for goods from the foreign market in the UK will be reduced. This will effectively solve the balance of payments. On the contrary, a balance of payments excess ought to be eradicated by an appreciation of the value of the UK Sterling pound. Secondly, a floating exchange rate regime has the advantage of freeing the policy that is made internally (Griffiths & Wall, 2012). With this type of an exchange rate regime, the disequilibrium in the balance of payments ought to be corrected by a variance in the external value of the currency. This is unlike a fixed rate currency regime that would encompass a general policy that is deflationary. This will definitely give an outcome of a very nasty outcome for the entire economy such as issues of unemployment. The floating exchange rate regime enables a country to have the liberty to pursue its own interior policy objectives. Such types of internal policy objectives would be like the growth of the economy as well as complete establishment of jobs without any external limitations. Thirdly, a floating exchange rate regime ensures that there are no crises. It is common knowledge that the fixed rate regimes are habitually characterized by a myriad of predicaments. This is especially due to the fact that a lot of pressure is built for a currency to either devalue or increase. This is unlike the floating exchange rate regime in which devaluing or revaluing of the currency of a country is automatic ensuring that no crises are occasioned from a country’s international relations (Begg, Fischer & Dornbusch, 2008). Fourthly, a floating exchange rate regime is characterized by flexibility. Fox example during the post-1973, the world trade experienced major pattern changes as well as major variations in the economics of the world (Griffiths & Wall, 2012). This was especially occasioned by the shocks experienced in the oil industry by the Organization of the Petroleum Exporting Countries (OPEC). A fixed exchange rate regime in this situation would have occasioned major difficulties at this period as some of the countries would be uncompetitive considering their rates of inflation. A floating exchange rate regime would have enabled a country to re-adjust more flexibly to those external astonishments. Lastly, a floating exchange rate regime allows a country to have minimal foreign exchange reserves. A country that has a fixed exchange rate regime is always forced to have in possession huge amounts of foreign currency in order for it to be ready for periods when it has to defend that fixed exchange rate regime. However, there types of reserves come with an opportunity cost (Sloman, Wride & Garratt, 2012). Relative Disadvantages of Operating a Floating Exchange Rate Regime Despite the many advantages that a floating exchange rate regime has, it also has its own disadvantages. First, a floating exchange rate regime has uncertainties. The fact that value of the currency of a particular country is in a position to change from day to day means that the trade will experience uncertainties as well as instability (Krugman, Wells & Graddy, 2008). The sellers of goods may be uncertain of the amount of money that they will obtain if they sell their goods in a foreign market. They will also be uncertain of the exchange rates of their currency in the foreign market. This means that a floating exchange rate regime is capable of affecting both the sales as well as the prices of those sales. On the same note, those traders who import their goods from foreign markets will not be sure of the amount of money that it will cost them for the imports from the foreign market. This type of uncertainty can nonetheless be abridged by circumventing the threat of the foreign exchange on the accelerative market. Secondly, there are arguments that a floating exchange rate regime does not spontaneously remedy a balance of payments deficit. The experience that the UK has gone through indicates that a floating exchange rate regime in all probability does not remedy a deficit in the balance of payments. Much hinges on the elasticity of price of demand for both the exports as well as the imports. According to the Marshall-Lerner condition, devaluation in the exchange rate will assist in enhancing the balance of payments if the total of the price elasticity for both the exports as well as the imports is more than one (Begg, Fischer & Dornbusch, 2008). Thirdly, a floating exchange rate regime is capable of occasioning inflation. Research shows that inflationary conditions in most countries are often as a result of a floating exchange rate regime (Griffiths & Wall, 2012). The floating exchange rate regime causes inflationary conditions in a country as it allows the prices of imports to heighten as the exchange rate declines. This is in addition to it trying to punish economies which are inflationary which is obviously not a solution as it is responsible for encouraging inflation in a country. This is specifically the case for a country such as the UK which is almost entirely dependent on imports from the foreign market for its needs of raw materials as well as food. Fourthly, a floating exchange rate regime can lead to a lack of discipline in the management of the economy of a country. As we have earlier seen, inflation often goes unpunished. This presents an endangerment in that the governments of countries will be more willing to make use of economic policies that are inflationary. This will definitely lead to a certain level of inflation that can be responsible for negative outcomes for the economy of that country. A solution to this kind of a problem would undoubtedly be the manifestation of a target for the inflation in a particular country (Sloman, Wride & Garratt, 2012). Lastly, a foreign exchange rate regime leads to a lack of investment as well as speculations in the country (Begg, Fischer & Dornbusch, 2008). The uncertainties that are characterized by a floating exchange rate regime, people can be afraid to make any kind of investments both internally as well as in the foreign markets. The government may equally be unwilling to make any form of investments. A lack of investments in any given country definitely means that the economy of that country is bound to suffer due to the absence of investments to boost it. The inflation rates are equally bound to rise. Speculation brings harm to the economy of a country as the flows that have been speculated may in most cases be different from the fundamental arrangement of trade currents. Speculation being an inherent part of a floating exchange rate regime is therefore destructive as well as destabilizing for the economy concerned. Conclusion From the foregoing analysis, it is clear that a floating exchange rate regime has both benefits and disadvantages. A country therefore ought to carry out a cost-benefit analysis of the floating system before opting for it. References Begg, D., Fischer, S. & Dornbusch, R. (2008) Economics, 9th edition, McGraw-Hill Griffiths, A. & Wall, S. (2012) Applied Economics, 12th edition, Longman Krugman, P., Wells, R. & Graddy, K. (2008) Economics, European Edition,Worth Sloman, J., Wride, A. & Garratt, D. (2012) Economics, 8th edition, London: Prentice Hall Read More