SESSION 1 ADVANTAGES AND DISADVANTAGES OF FLOATING EXCHANGE RATES Issues & Problems SESSION 1 ADVANTAGES AND DISADVANTAGES OF FLOATING EXCHANGE RATES By Dr. Soha El Magawry

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Advantages of Floating Exchange Rates: No need for international management of exchange rates: Unlike fixed exchange rates based on a metallic standard, floating exchange rates don’t require an international manager such as the International Monetary Fund to look over current account imbalances. Under the floating system, if a country has large current account deficits, its currency depreciates.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Advantages of Floating Exchange Rates (continued): No need for frequent central bank intervention: Central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect the gold parity, but such is not the case under the floating regime. Here there’s no parity to uphold.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Advantages of Floating Exchange Rates (continued): No need for elaborate capital flow restrictions: It is difficult to keep the parity intact in a fixed exchange rate regime while portfolio flows are moving in and out of the country. In a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets, which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Advantages of Floating Exchange Rates (continued): Greater insulation from other countries’ economic problems: Under a fixed exchange rate regime, countries export their macroeconomic problems to other countries. Suppose that the inflation rate in the U.S. is rising relative to that of the Euro-zone.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Advantages of Floating Exchange Rates (continued): Under a fixed exchange rate regime, this scenario leads to an increased U.S. demand for European goods, which then increases the Euro-zone’s price level. Under a floating exchange rate system, however, countries are more insulated from other countries’ macroeconomic problems. A rising U.S. inflation instead depreciates the dollar, curbing the U.S. demand for European goods.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Disadvantages of Floating Exchange Rates: Higher volatility: Floating exchange rates are highly volatile. Additionally, macroeconomic fundamentals can’t explain especially short-run volatility in floating exchange rates.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Disadvantages of Floating Exchange Rates (continued): Use of scarce resources to predict exchange rates: Higher volatility in exchange rates increases the exchange rate risk that financial market participants face. Therefore, they allocate substantial resources to predict the changes in the exchange rate, in an effort to manage their exposure to exchange rate risk.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Disadvantages of Floating Exchange Rates (continued): Tendency to worsen existing problems: Floating exchange rates may aggravate existing problems in the economy. If the country is already experiencing economic problems such as higher inflation or unemployment, floating exchange rates may make the situation worse.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens Disadvantages of Floating Exchange Rates (continued): For example, if the country suffers from higher inflation, depreciation of its currency may drive the inflation rate higher because of increased demand for its goods; however, the country’s current account may also worsen because of more expensive imports.

Advantages & Disadvantages of Floating Exchange Rates Session 1 Issues & Problens END of SESSION 1