Floating Exchange Rates: Are They Healthy Or Harmful? Have A Look

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Floating exchange rate or fixed exchange rate is one question that strikes economists' minds frequently. Opposite to Fixed exchange rate; floating exchange rates are used to refer to freely changing exchange rates determined by the trading in the FOREX market. Generally for any country with its foreign exchange rate determined by the supply and demand for that particular currency relative to other currencies uses this terminology.

At times, floating exchange rates are more preferred than fixed exchange rates as it helps the country to balance out the payment crisis. This happens as the floating exchange rates are adjusted automatically according to the current market conditions. Thus, they the foreign business sectors and the impacts of shock are dampened. But for better certainty and stability, sometimes fixed exchange rate is preferred over floating.

Since many years, Mundell-Fleming model has proved to be a useful model to make decision between the regimens of floating and fixed exchange rate. This model suggests that any economy is dependent on 3 factors: exchange rate, capital movement and monitory policies. A country needs to maintain two aspects while leave the third one to adjust itself. For example, economy of any country cannot maintain any fixed exchange rates with free capital movement along with a monetary policy that is independent. Thus, it needs to choose two among the three.

Now the question arises what happens in the case if there is extreme appreciation or depreciation or appreciation. Under such circumstances the central bank of any country will gets involved to handle such situation and stabilize its currency. The central bank allocates the lower and upper bound for currency price, generally known as floor and ceiling. Then it allows the currency price to float freely between the two. Along with this the bank management supports the country's economy by selling or buying in large lots for providing price resistance and support. In certain cases the bank levies heavy legal penalties if there is any trading of national currencies outside the bound limits.

Economists believe that free floating exchange rates can cause problems for an emerging economy as it increase the volatility of foreign exchange and as it threaten the stability of the domestic financial system. An emerging economy generally falls under one of the three financial sector conditions such as:

Thus, adoption of floating or fixed exchange rate is highly dependent on the economic conditions of any country.

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