Floating exchanges rates have both advantages and disadvantages. Some of the advantages include: first, it used to eliminate excess volatility because the central bank of each country is at a position of the determining exchange rate based on the predetermined goal but the set exchange rate is allowed to vary depending on the changes on the BOP, foreign exchange reserves and rate which is quoted outside official market (Nipan, 2020). Essentially, in floating exchange rates, authorities and government intervene and create a financial environment that reduces uncertainty. For example, when there is uncertainty in the exportation, disruptive exchange rate changes can be implemented which help counter exporter’s uncertainty. Second, use floating exchange rates systems protect economies from external shocks (Nipan, 2020). For example, a decrease in the oil prices as a result of the decrease in the customer demand, attributable to disruption in the supply chain due to impact of the COVID-19, economies with floating exchange rates respond accordingly. Finally, in the floating exchange rates, BOP deficit corrects automatically. For example, when there is BOP deficit, floating exchange rate tends to depreciate thus making the exports competitive restoring equilibrium to the BOP (Nipan, 2020).
On the part of the disadvantages of the floating exchange rate systems include: there is a high level of the uncertainty because the value of the currency keeps on changing which may adversely affect business people; may discourage investment because companies are not sure whether the currency will appreciate or depreciate given the high level of the uncertainty with this type of the exchange rate and finally, fluctuation in the day-to-day exchange rates could cause people to make speculation on the future of the exchange rate which might lead to high rate of the exchange rate fluctuations (Nipan, 2020).
The free market economy would be the best system that would be most suitable in the present economy. This is because it would promote production efficiency, entrepreneurship and effective allocation of the resources (Agarwal, 2020). Multinational companies would develop innovative ways of the risk management which would help in reducing some levels of the volatility that are currently experienced. Similarly, in the free economy, integration of the economies will be enhanced and use of the foreign money market that will help in reducing to a bigger extent foreign exchange rate risk.
Other student reply to me:
I agree that a major disadvantage of having a floating exchange rate is the uncertainty companies face when doing business with other countries. I was wondering in general how many countries have been affected by this pandemic because not only are countries buying less, they’re now getting themselves into debt as the currency devalues all over the world. At the same time, it’s interesting because it is all dropping at the same time so perhaps it will also restore at the same time. Here’s to hoping for a bright side.
Please write a response to that comment.
One of the advantages inherent to a floating exchange rate system is the fact that the main determinant in the rate values are market forces. This allows for complete flexibility as the exchange rate value adjusts on a continual basis to changes in supply and demand. Such a system allows a country to be more insulated, or less effected by inflation of other countries. If the US experiences high inflation rates, then another country with whom they trade with, such as the UK, will purchase less goods since the value of the pound is worth less in comparison to the dollar that it was before. The pound will consequently appreciate in value in comparison to the dollar, which will cause goods from the UK to appear more expensive to the US when in fact the price has not risen, but a great number of US dollars is required to make the purchase due to the dollars inflation. This allows for an advantage to the UK, but a clear disadvantage in the system for the US as goods purchased from the UK will require more dollars to purchase. Under a fixed rate system, government intervention would allow the US to purchase goods from another nation to avoid the increase in price due to the countries own inflation.
Similarly, poor unemployment rates in one country have less effect on other countries. If the US were to lower the amount of goods purchased from the UK due to economic uncertainty, the demand for the British pound would decrease as well to the US. This could cause the dollar to appreciate to the pound, which will make goods from the UK require a lower number of US dollars to purchase. But this also creates a disadvantage for the country where unemployment is high as foreign goods will be purchased at a far greater rate than domestic goods do to the lower price, or lower amount of dollars required to make the purchase. Under a fixed rate system, the UK government would intervene in a way to maintain the value of the pound even if the US were to lower the number of goods, they purchased from them. The US government would also intervene be offering incentives to domestic manufacturers.
An alternative system that might be better suited to manage the present world economy is the pegged exchange rate system. Under this system, a countries exchange rate value is “pegged” a foreign nations currency or to an index of currencies. Many countries peg their currency to the US dollar as a means of stabilizing that countries exchange rate since the US dollar is a stable currency. This allows the foreign nations currency to “move against non-dollar currencies to the same extent as the dollar does.2” If more countries were to employ the pegged exchange rate system, the economies of these nations would move in conjunction with one another.
Please comment on student 2’s answer