Floating Exchange Rate
The floating exchange rate is a market-driven price for currency, whereby the exchange rate is determined entirely by the free market forces of demand and supply of currencies with no government intervention whatsoever.
Broadly, the floating exchange rate regime consists of the independent floating system and the managed floating system. The former is where exchange rate is strictly determined by the free movement of demand and supply. For managed floating system, exchange rate is also determined by free movement of demand and supply but the monetary authorities intervene at certain times to "manage" the exchange rate to prevent high volatilities.
Pros & Cons of Floating Exchange Rate
The floating exchange rate boasts various merits. Firstly, there is automatic correction in the floating exchange rate as the country simply lets it move freely to the equilibrium of demand and supply. Secondly, there is insulation from external economic events as the country's currency is not tied to a possibly high world inflation rate as is under a fixed exchange rate. The free movement of demand and supply helps to insulate the domestic economy from world economic fluctuations. Thirdly, governments are free to choose their domestic policy as a floating exchange rate would allow for automatic correction of any balance of payment disequilibrium that might arise from the implementation of domestic policy.
Nonetheless, there are also specific concerns about the exchange rate being unstable and uncertain under the floating exchange rate regime. Also, speculation tends to be higher in the floating exchange rate regime, hence leading to more uncertainty especially for traders and investors.
Fixed Exchange Rate
For a fixed exchange rate, the government is unwilling to let the country's currency float freely, and they state a level at which the...
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