Operating with a free-floating exchange rate, also known as a flexible exchange rate, has both advantages and drawbacks.
Advantages of Free-Floating Exchange Rates:
- Monetary Policy Autonomy: Countries with free-floating exchange rates have greater flexibility in conducting an independent monetary policy. This means that they can adjust interest rates and the size of quantitative easing to address domestic economic conditions such as growth, inflation and unemployment without being constrained by exchange rate considerations.
- Shock Absorption: Free-floating exchange rates allow countries to absorb external economic shocks more effectively. If a country faces an economic crisis, such as a recession, the exchange rate can act as a shock absorber by helping to rebalance the economy. For example, a recession might cause the exchange rate to depreciate which acts as a boost to export businesses and domestic firms facing import competition.
- Reduced Speculative Attacks: Since exchange rates are determined by market forces, speculative attacks on a currency are less likely although not impossible. Traders and investors are less likely to attempt coordinated efforts to manipulate the exchange rate for short-term gains.
- Trade Balance Adjustment: A floating exchange rate can help correct trade imbalances over time. If a country is running a large trade deficit, its currency's depreciation can eventually make its exports more price competitive and imports more expensive, leading to a narrowing of the deficit. This depends on the price elasticities of demand for exports and imports along with the elasticity of supply of domestic firms.
- Currency reserves: When operating a free-floating exchange rate system, the central bank does not need to hold large foreign currency reserves because there is no specific currency target, financial capital can flow freely across countries seeking the best returns
Drawbacks of Free-Floating Exchange Rates:
- Exchange Rate Volatility: One of the most significant drawbacks of a free-floating system is the potential for exchange rate volatility. Currencies can experience rapid and unpredictable fluctuations, which can introduce uncertainty for businesses engaged in international trade and investment.
- Currency Risk: The volatility of exchange rates introduces currency risk for businesses and investors.
- Inflation Pass-Through: Exchange rate fluctuations can lead to changes in import prices, which can impact domestic inflation. A significant depreciation of the currency can contribute to imported inflation and erode real purchasing power.
- Loss of Exchange Rate as a Policy Tool: While countries gain monetary policy autonomy, they lose the ability to manage the exchange rate as a deliberate policy tool. This can limit the direct influence of exchange rates on trade and competitiveness.
