By FMTeam Do you know and have ever heard of the US Dollar? Yes, that is the prime example of what a floating currency is. And to explain it in the simplest words possible, well, a floating exchange rate is when the value of a nation’s currency is actually determined by the market itself. Like, if it is used or bought more, then it’ll get stronger against other currencies. Simple as that! And we know that you have questions like What good is it? Are there any downsides to floating exchange rates too? Well, yes, there are both, just like anything else in life, and today, we’ll be taking a good look at just that. Why? That’s because this post is all about floating exchange rate advantages and disadvantages. So, here we go now.
Advantages of a Floating Exchange Rate
1. Freedom to Control Your Own Economy
Did you know that one if not the main and best advantages of having a floating exchange rate system is the power it gives the nation to completely regulate its monetary policy? Like, accordingly, the state and the Central Bank can modify such basic parameters as interest rates with a view toward the economy with no need to fear a break in the peg of the currency. And just so you know, since the country is free to fluctuate its currency within a floating exchange rate regime, it is better able to take corrective actions for economic problems internally, that’s kinda one of the best bits, don’t you think?
2. Trade Balances? No Problem
What do we mean by this point though? Well, just to illustrate, you see, if a given country has a trade deficit, that is, it imports more than it exports, the local currency will depreciate in the first instance. What effect does that have? Well, in turn, this will render the exports of the local venture cheaper for the foreign clients, and hence the sales of the product will rise. And just so you know, this pattern of events should be able to be seen correcting the unhealthy imbalance independently of the government action.
3. Acts Like a Safety Net in Tough Times? Sure!
We’d like to tell you that a simple exchange rate system is a flexible instrument for the economy of the country and it is also referred to as a buffer for the economy in case of adverse events such as a global recession or a drop in the price of a strategic commodity, which is a real economic shock, right? And to be honest, such self-adjustment can lessen the strength of external shocks that might have been inflicted on the economy.
4. No Need to Hoard Foreign Cash
Did you know that in nations that utilize a fixed exchange rate, the government must keep big quantities of foreign currency reserves for their national currency to be stable? However, this does not apply to the market with a floating currency exchange, and why is that? Well, since the market determines the value of the currency by supply and demand, it is useless to have stocks of foreign reserves.
5. Less Risk of “Imported” Inflation
Generally in countries with a fixed currency abroad, its inflation could be imported, and we know that you’ll be like: Is that even possible? Well, yes, it is! You see, a country can be exposed to such a risk of inflation by the prices of imported goods rising which leads to the overall inflation in the country. But the thing is, if there is a floating-rate currency in place, this risk is significantly minimized because the currency automatically adjusts to the state of the market.
6. Reflects What’s Really Going On in the Economy
What’s more about this type of exchange rate? Well, just so you know, as it allows investors to make decisions based on real economic conditions, it makes them more effective. It also lets money cross the borders with freedom which attracts investments, thus, a country’s economy is able to profit from the output of the location to some extent by boosting growth and production.
Disadvantages of a Floating Exchange Rate
1. The Value Can Change… A Lot
Floating exchange rates can bring the biggest drawbacks to the table because one can see a significant change in currency values over a short time. And sure, we know that it can be a headache for businesses and individuals, mainly in international trade, using foreign currencies. Like, if a business does exports, it could happen that the profits increase or decrease day by day as the currency exchange ratio varies, and that’s not a good thing at all. That is way too much uncertainty.
2. Currency Risk Is Real
Currency risk? Yes, it’s a fact and real! Like, the currency risk that companies undertake is in the form of a total loss of earnings in an open market. For example, a company importing products from abroad may have to pay a higher price for the company’s product because of the erosion of its currency, you know? To avoid losses in such cases, companies rely on hedging which is generally a costly and challenging process.
3. Inflation Can Sneak In
In general, when depreciation occurs in a national currency’s value, the costs of imported products increase. As a consequence, the skyrocketing prices of foreign products push up inflation, which we have seen happen. If an economy relies heavily on imported energy, for instance, it will highly be affected if the currency is devalued. It exercises pressure both on the price and the supply of gas, as well as on the economy as a whole.
4. Less Control Over Growth
Because a floating system’s exchange rate is market-driven, a government cannot directly intervene, did you already know that? And if you really think about it, it really gives the government less control over growth and the economy as a whole.
Conclusion
That’s all. So, as you saw how floating exchange rates can work in the favor of some nations, and for some, it can become a headache. But it all depends upon a few factors that we talked about in this post. We hope now you know much better about it all.