The foreign exchange market or forex is the largest market in the world. As of 2009, more than $3 trillion is traded in the markets on a daily basis. When we travel to a different country, it helps to have their currency on hand for our expenses. Trading in your money in exchange for another involves an exchange rate, which is the rate one currency can be changed for another. For instance, as of this writing 1 USD is equal to 0.77 GBP (British Pound).
Exchange rates can be fixed or floating and this article will tackle the latter including its pros and cons. A floating exchange rate is determined by the private market based on supply and demand whereas the fixed rate is decided by the central bank.
Now that you know the basic difference between the two, here’s a look at what makes a floating exchange rate good or bad:
List of Pros of Floating Exchange Rate
1. It is self-correcting.
As mentioned, floating exchange rates don’t depend on the central bank but on the market. Any differences in the supply and demand will be reflected automatically. If the demand for a certain currency is low, its value will decrease which results in imported goods being more expensive and thus driving demand for local goods and services. As such, more jobs can be generated through auto-corrections in the market. In short, a floating exchange rate is never fixed.
2. It offers protection from external economic events.
The currency of a country won’t be affected should there be any economic movement in other nations. When supply and demand moves freely, the domestic economy is protected from fluctuations in the world economy. This is possible because the currency is not linked to a high inflation rate unlike a fixed exchange rate.
3. It gives governments the freedom to choose their domestic policy.
Governments can do this with a floating exchange rate because it self-corrects any balance of payment disequilibrium arising from domestic policy implementation.
List of Cons of Floating Exchange Rate
1. It has higher volatility.
A floating exchange rate is highly volatile. Plus, short-run volatility in this kind of market can’t be explained by macroeconomic fundamentals.
2. It uses scarce resources to predict exchange rates.
When there exchange rates are highly volatile, the risk faced by financial market participants face is greatly increased. This is why substantial resources are used to predict exchange rate changes so that the exposure to risk can be managed.
3. It can make existing problems worse.
If a country is already experiencing economic troubles like high inflation rates, currency depreciation may likely cause the inflation rate to soar even higher because the demand for its goods has risen. The conditions may even get worse because of expensive imports.
A fixed exchange rate has been proven to create global trade as well as provide monetary stability. However, it was used when major economies took part in it. So even if a floating exchange rate has its set of flaws, it is more efficient in being able to determine the value of a currency as well as creating equilibrium in the international market.
Natalie Regoli, Esq. is the author of this post and the editor-in-chief of our blog. She received her B.A. in Economics from the University of Washington and her Masters in Law from The University of Texas School of Law. In addition to being a seasoned writer, Natalie has almost two decades of experience as a lawyer and banker. If you would like to reach out to contact Natalie, then go here to send her a message.