In this article, We learn about “Floating exchange rate “.Let’s Go!
A fFloating exchange rate refers to a currency that is subject to the influence of the open market and is allowed to change freely, rather than being fixed to the value of another currency.
A floating exchange rate system determines the value of one currency relative to other currencies.
Unlike fixed exchange rates, these currencies constantly fluctuate and float freely. They are not subject to government controls or trade restrictions.
Changes in factors such as interest rates, inflation, political stability, capital flows, trade flows, employment, tourism, and speculation keep free-floating currencies constantly changing.
For currency speculators, who make up the vast majority of Forex trading, this kind of volatility is considered a good thing.
For companies that do business in foreign currencies, it creates translation and currency risks that can severely impact their profit margins.
Advantages of floating exchange rates
Balance of payments is stable
Theoretically, imbalances in the balance of payments will cause the exchange rate to change automatically. For example, a balance of payments deficit can trigger currency depreciation.
This will make a country’s exports cheaper in foreign markets, increasing demand and ultimately restoring the balance of payments.
Unrestricted foreign exchange and capital movement
Unlike fixed exchange rates, there are no restrictions on trading with these currencies. Therefore, there is no need for ongoing management processes by governments or central banks.
No need to keep large foreign exchange reserves
A freely floating exchange rate does not require the central bank to hold large foreign exchange reserves to defend the exchange rate. Therefore, these reserves can be used to import capital goods to promote economic growth.
Prevent imported inflation
One of the biggest problems facing countries with fixed exchange rates is that they can introduce inflation through higher import prices or balance of payments surpluses in deficit countries. Countries with freely floating exchange rates do not have this problem.
Disadvantages of floating exchange rates
Higher risk of exchange rate fluctuations
By nature, floating exchange rates are volatile and prone to violent fluctuations. The value of one currency against another can fall sharply in a single day.
Lack of monetary controls can hinder economic recovery or growth
Negative exchange rate movements in a country’s currency can cause serious problems.
For example, if the yen appreciates against the euro, it will become more difficult for Japanese exports to the euro area.
On the other hand, currency depreciation tends to increase inflation. Therefore, the government must be alert to fluctuations and take measures to promote stable economic growth.
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