What is exchange rate? Discuss Advantages & Disadvantages of floating exchange rate regime

 Definition: Exchange rate is the price of one currency in terms of another currency. Exchange rates can be either fixed or floating. Fixed exchange rates are decided by central banks of a country whereas floating exchange rates are decided by the mechanism of market demand and supply.

Advantages

 §  Market Determined Rates: Floating exchange rate means that the market will determine the rate at which one currency can be exchanged for another. The market will set these rates on a real time basis as and when new information flows in. This reduces the need for an elaborate mechanism to ensure that the exchange rates remain within a particular range.

§  Independence: Floating exchange rates allow the governments and central banks of a nation to have a great degree of independence. In case of fixed exchange rates, the Central banks of different nations have to act in tandem.

§  Less Probability of Speculative Attacks: A freely floating currency faces adjustment on a minute to minute basis. There are some days that the currency faces rapid appreciation whereas others when it faces rapid decline. However, for most of the days, the currency remains stable. However, if the currency is traded on the Forex market as a freely floating currency, adjustments happen on a minute to minute basis.

§  Low Requirement of Reserves: A floating exchange system does not require the central bank to hold massive reserves. This is because the Central Bank does not have to conduct active trading operations in order to maintain the value of the currency. Central Bank operations are a very rare event for countries that have a floating rate system. This is a major advantage of this system since holding foreign exchange for trading purposes is an expensive strategy. Firstly, it requires the country to maintain a huge currency reserve.

 

Disadvantages

 The floating currency system also has its critics. They suggest that the system has a few serious flaws. Some of the important ones have been listed below:

 §  Uncertainty: Firstly, a floating exchange rate implies a lot of volatility. The value of currencies change on a real time basis. Also, since Forex market is not regulated, currency values could skyrocket or hit rock bottom in a matter of minutes.

§  Allocation of Resources: At a macro level, the economy faces a problem while allocating resources. This is because as exchange rates change so does the benefit that can be derived from resources. For instance, a rising exchange rate makes imports a better option whereas a falling rate makes exports easier.

§  Lack of Discipline: Lastly, floating exchange rates only make sense if the country has sufficient internal control mechanisms in place. Hence, if there is likelihood that the monetary policy may be misused for personal gains by a group of influential people, then it is better to peg the currency to another more developed currency.