Floating Exchange Rate - Economic Rationale

Economic Rationale

There are economists who think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. As floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis.

However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency "strong" or "high" relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis.

The debate of making a choice between fixed and floating exchange rate regimes is set forth by the Mundell–Fleming model, which argues that an economy (read: government) cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. It can choose any two for control, and leave the third to market forces.

The primary argument for a floating exchange rate is that it allows monetary policies to be useful for other purposes. Under fixed rates monetary policy is committed to the single goal of maintaining exchange rate at its announced level. Yet the exchange rate is only one of many macro economic variable that monetary policy can influence. A system of floating exchange rate leaves monetary policy makers free to pursue other goals such as stabilizing employment or prices.

In cases of extreme appreciation or depreciation, a central bank will normally intervene to stabilize the currency. Thus, the exchange rate regimes of floating currencies may more technically be known as a managed float. A central bank might, for instance, allow a currency price to float freely between an upper and lower bound, a price "ceiling" and "floor". Management by the central bank may take the form of buying or selling large lots in order to provide price support or resistance, or, in the case of some national currencies, there may be legal penalties for trading outside these bounds.