In this article we will discuss about the advantages and disadvantages of floating exchange rates.

Advantage of Floating Exchange Rates:

Floating exchange rates have the following advantages:

1. Automatic Stabilisation:

Any disequilibrium in the balance of pay­ments would be automatically corrected by a change in the exchange rate. For example, if a country suffers from a deficit in the balance of payments then, other things being equal, the country’s currency should depreciate.

This would make the country’s exports cheaper, thus increasing demand, while at the same time making imports expensive and decreasing demand. The balance of payments equilibrium would therefore be restored. On the contrary, a balance of payments surplus would be automatically eliminated through a change in the exchange rate.

2. Freeing Internal Policy:


Under the floating exchange rate system the balance of payments deficit of a country can be rectified by changing the external price of the currency. On the country if a fixed exchange rate policy is adopted, then reducing a deficit could involve a general deflationary policy for the whole economy, resulting in unpleasant consequences such as unemployment and idle capacity.

Thus, a floating exchange rate allows a government to pursue internal policy objectives such as full employment growth in the absence of demand-pull inflation without external con­straints (such as debt burden or shortage of foreign exchange).

3. Absence of Crisis:

The periods of fixed exchange rates were frequently characterised by crisis as too much pressure was put on central bank to devalue or revalue the country’s currency. However, the central bank that devalued a currency by giving out too much of it would soon either stop or run out of it.

Similarly the central banks that revalued a currency by giving out too little of it in exchange for other currencies would soon be flooded with that currency as it would get relatively large amounts of other curren­cies. Under floating exchange rate system such changes occur automatically. Thus, the possibility of international monetary crisis originating from ex­change rate changes is automatically eliminated.

4. Management:


J. E. Meade has pointed out that under the floating exchange rates system national governments enjoy considerable discretion. To be more specific, governments are free to manipulate the external value of their currency to their own advantage.

5. Flexibility:

Changes in world trade since the first oil crisis of 1973 have caused great changes in the values of currencies. How these could have been dealt with under a system of fixed exchange rate is not yet clear.

6. Avoiding Inflation:

John Beardshaw has argued that, “A floating exchange rate helps to insulate a country from inflation elsewhere. In the first place, if a country were on a fixed exchange rate then it would ‘import’ inflation by way of higher import prices. Secondly, a country with a pay­ments surplus and a fixed exchange rate would tend to ‘import’ inflation from deficit countries.”

7. Lower Reserves:

Finally, floating exchange rates should mean that three is hardly any need to maintain large reserves to develop the economy. These reserves can therefore be fruitfully used to import capital goods and other items in order to promote faster economic growth.

Disadvantages of Floating Exchange Rates:

Floating exchange rates have the following disadvantages:

1. Uncertainty:


The very fact that currencies change in value from day to day introduces a large element of uncertainty into trade. A seller may not be quite sure of how much money he will receive when he sells goods abroad. Some of this uncertainty may be reduced by companies buying currency ahead in forward exchange contracts.

2. Lack of Investment:

The uncertainty introduced by floating exchange rates may discourage direct foreign investment (i.e., investment by multi­national companies).

3. Speculation:

The day-to-day fluctuations in exchange rates may en­courage speculative movements of ‘hot money’ from country to country, thereby cause more and mooring exchange rate fluctuations.

4. Lack of Discipline:

The need to maintain an exchange rate imposes a discipline upon the national economy. It is quite possible that with a floating exchange rate such short-run problems as domestic inflation may be ig­nored until they have created crisis situations.