Floating Exchange Rate

Floating Exchange Rate

Floating Exchange Rate (at which domestic currency exchanges for gold or foreign currencies), one which is allowed to fluctuate according to supply and demand in the foreign exchange markets. The exchange rate is rarely completely free-moving. Normally the central bank or Exchange Equalization Account uses its reserves to buy or sell in the market to at least moderate day-to-day or week-to-week variations in demand and supply, but the intention is usually that the external exchange rate should reflect the long-run conditions of supply and demand for the currency. Such adjustments of the external rate might be expected to act as an automatic regulator of the balance of payments, restoring equilibrium whenever it is disturbed. For this reason a floating rate has many advocates among economists. Others argue, first, that a freely fluctuating exchange rate increases uncertainty and may discourage trade (this can be insured against at a cost by covering transactions in the forward exchange market). Secondly, it may increase speculation, causing flights of 'hot money' when the rate begins to depredate. Thirdly, small changes in an exchange rate may have insignificant or even adverse effects on the balance of payments because of time-lags and frictions which reduce the elasticities of demand for exports and imports i.e. the responsiveness of consumers to price changes. Fourthly, in even mildly inflationary conditions, depreciation of the exchange rate may spark off increases in cost and demand that will worsen the inflation.

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