Floating Exchange Rates

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Floating Exchange Rates

The exchange rate refers to how much of a foreign currency one unit of domestic currency will buy you. £1=$1.40 means that £1 of sterling will buy $1.40 of US dollars.

Floating exchange rate

With floating exchange rates, the government or central bank let the foreign exchange markets set exchange rates.
The value of a floating exchange rate is affected by the supply and demand of the currency in public markets.

Effect of interest rates

Expansionary monetary policy usually lowers interest rates to increase demand in the economy. This affects foreign exchange markets because:
- The lower interest rates will reduce demand for the currency because returns in that country are lower, leading to a depreciation in the domestic currency.
A central bank can also influence FX markets directly. It can increase the supply of its own currency (£) and buy other foreign currencies, again depreciating the domestic currency.

Volatility of floating rates

Supporters of floating exchange rates argue that if government policies were more predictable and stable, then inflation rates and interest rates would be more predictable and stable.
But floating exchange rates have been more volatile than economists expected them to be in the 1970s.

SPICEE!

There is an easy way to remember the impact of an exchange rate movement: SPICEE!
Strong.
Pound.
Imports.
Cheaper.
Exports.
Expensive(r).

Advantages of Floating Exchange Rates

Floating exchange rates are when the external value of a currency can change continuously because of market forces (due to supply and demand for that currency). There are several advantages to this system.

Stabilise balance of trade

A free floating currency allows for an automatic adjustment mechanism.
- E.g. if there is a current account deficit, this will lead to outflow of currency, causing a depreciation of the currency.
- This depreciation will lead to a greater competitiveness of exports. This will help to improve the current account and partially correct the problem.
When demand for exports rise, the value of the currency will rise making exports more expensive and when demand for exports falls, the value of the currency will fall making exports cheaper.

Freedom to use monetary policy for other aims

It is not possible for a country to have fixed exchange rates, perfect capital mobility and independent monetary policy. This is called the monetary trilemma.
Sacrificing control over exchange rates allows capital (funds) to flow freely into a country, which encourages investment, and also for the central bank to have control over the interest rate, allowing them to better manage inflation.

Less need to hold reserves

With floating rates, there is no obvious need for a central bank to hold foreign exchange reserves. This is because a key reason to hold them is to intervene in the currency market.
With a fixed exchange rate, the Central Bank needs to hold reserves and is vulnerable to speculation.

Disadvantages of Floating Exchange Rates

Floating exchange rates are when the external value of a currency can fluctuate because of market forces (that is, due to supply and demand for that currency). There are also disadvantages to this system.

Increased uncertainty

Increased uncertainty over the exchange rate could mean that long term international investment is discouraged because potential investors will be of unsure of future prices.
This hampers business confidence, which in turn deters investment and could give rise to a negative multiplier.

Cost-push inflation from depreciation

If a currency depreciates, the price of imports rises. This could lead to imported raw material costs rising, leading to cost-push inflation.
Less macroeconomic discipline is needed by a government - if the domestic inflation is higher than foreign inflation rates, the currency will depreciate. This will reduce the difference the impact the inflation is having.

Potential speculation

A freely traded currency can still be vulnerable to speculation as investors try to make investment returns by trading FX.
Higher levels of speculation could in turn increase volatility.