Type of Basic Mechanisms for Exchange Rates
1. Type of basic mechanisms for exchange rates
a). Free float
Free floating or clean float is a type of country’s exchange rate regime where a currency’s value is allowed to fluctuate according to the foreign exchange market. Free floating exchange rate is determined by the interaction of currency supplies and demands with no government intervention.
It always termed “self- correcting’ as if any differences in supply and demand, the exchange rate will automatically be corrected in the market. For instance, if demand for one country’s currency is low, its value will decrease and vice versa. Thus the imported goods will become more expensive and stimulating demand for local goods and services. Other than that, in a free float, as economic parameters change, for example, the new government policies or acts of nature, the market participants will adjust their current and expected future currency needs.
Based on the diagram, it is shown that exchange rate appreciates when demand for currency (D1 to D2) increases.
Based on the diagram, it shows that increases in currency supply (S1 to S2) will cause the value of currency to drop.
Advantages
* Automatic balance of payments adjustment
Firstly, there will automatic correction in the floating exchange rate as the country will simply move freely according to demand and supply of the market and achieve equilibrium based on market condition. Any balance of payment disequilibrium will tend to be rectified in the exchange rate.
For example, if the balance of payments deficit, it means the currency deficit too. The floating exchange rate system will adjust a currency outflow or inflow into the currency. The floating exchange rate system will automatically makes the domestic goods either more competitive (in case of appreciation on the currency market) or makes foreign goods more competitive (in case of the currency’s depreciation).
* Flexibility
Free floating is the flexibility feature which
a). Free float
Free floating or clean float is a type of country’s exchange rate regime where a currency’s value is allowed to fluctuate according to the foreign exchange market. Free floating exchange rate is determined by the interaction of currency supplies and demands with no government intervention.
It always termed “self- correcting’ as if any differences in supply and demand, the exchange rate will automatically be corrected in the market. For instance, if demand for one country’s currency is low, its value will decrease and vice versa. Thus the imported goods will become more expensive and stimulating demand for local goods and services. Other than that, in a free float, as economic parameters change, for example, the new government policies or acts of nature, the market participants will adjust their current and expected future currency needs.
Based on the diagram, it is shown that exchange rate appreciates when demand for currency (D1 to D2) increases.
Based on the diagram, it shows that increases in currency supply (S1 to S2) will cause the value of currency to drop.
Advantages
* Automatic balance of payments adjustment
Firstly, there will automatic correction in the floating exchange rate as the country will simply move freely according to demand and supply of the market and achieve equilibrium based on market condition. Any balance of payment disequilibrium will tend to be rectified in the exchange rate.
For example, if the balance of payments deficit, it means the currency deficit too. The floating exchange rate system will adjust a currency outflow or inflow into the currency. The floating exchange rate system will automatically makes the domestic goods either more competitive (in case of appreciation on the currency market) or makes foreign goods more competitive (in case of the currency’s depreciation).
* Flexibility
Free floating is the flexibility feature which