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Floating Exchange Rates

Floating Exchange Rates
Published:   12 Dec at 9 AM

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A floating exchange rate or fluctuating
exchange rate as it is sometimes known is a kind of exchange rate regime
that involves a currency value being allowed to fluctuate according
to the foreign exchange market. Any currency that uses a floating exchange
rate is known, predictably, as a foreign currency. It is essentially
impossible for a developing nation to maintain the stability in the
rate of exchange for its currency in the exchange market.

There are many economists who believe
that in the majority of cases, a floating exchange rate is more beneficial
to a fixed exchange rate. As floating exchange rates automatically change
they allow a nation to soften the direct impact of certain shocks and
foreign business cycles and even to pre-empt the potential for a balance
of payments crisis. However, in some situations, the fixed exchange
rate may be a better solution in order to achieve a better level of
stability and certainty. This is however, quite debatable in that some
believe that considering the results of countries that are aiming to
keep the prices of their currency at a high level. An example of countries
who do this are the United Kingdom and the majority of Southeastern
Asia countries prior to the Asian currency crisis.

It is the Mundell-Fleming model that
originally set out the debate between fixed and floating exchange rate
regimes in which they state that an economy can't maintain a fixed
exchange rate, free capital movement and independent monetary policy
all at the same time. It is believed that a country can choose two out
of the three but the third must be left to the market forces.

In certain circumstances where an
economy is appreciating or depreciating, a central bank will often intervene
in order to fully stabilise a currency and prevent it's collapse.
For this reason, the exchange rate regimes of these floating currencies
can often be more accurately described as a managed float. For example,
a central bank may allow a currency price to float freely between upper
and lower bounds, a specified “ceiling” and “floor” during which
time the bank will not intervene. However, should the bank intervene,
it can come in the form of a purchasing or selling large lots in an
attempt to provide price support or resistance and even in some case,
there may be legal penalties for trading outside of these bounds. I

A free floating exchange rate increases
foreign exchange volatility. There are economists who think that this
could cause serious problems, especially in emerging economies. These
economies have a financial sector with one or more of following conditions:

- high liability dollarization

- financial fragility

  • strong balance sheet effects

When liabilties are denominated in
foreign currencies while assets are in the local currency, unexpected
depreciations of the exchange rate deteriorate bank and corporate balance
sheets and threaten the stability of the domestic financial system.For
this reason emerging countries appear to face greater fear of floating,
as they have much smaller variations of the nominal exchange rate, yet
face bigger shocks and interest rate and reserve movements.

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