Exchange rates are defined as the price of one currency as compared to another. The price is based on the specific rate mechanism adopted. With the floating-rate system, market forces directly impact and determine exchange rates. Changing market conditions cause the exchange rates to constantly fluctuate. In direct contrast, the fixed or managed rate system allows respective authorities to regulate the exchange rate to avoid volatility and uncertainties that are present in the floating exchange-rate system.
With a floating exchange rate, the fluctuations in the rates can help provide automatic adjustments in balance of payments. This is beneficial to countries with large deficits in their balance of payments. For example, an economy with a large balance of payments deficit means a net outflow of currency from the country, resulting in lowering the exchange rate. With the depreciation that occurs, the price of exports in foreign markets falls, making the exports more competitive. At the same time, the price of imports in the home market increases. This will help reduce the overall deficit in the country’s balance of trade.
Flexibility in Determining Interest Rates
A floating exchange rate system affords the government and monetary authorities the flexibility to determine interest rates. With this system, interest rates do not have to be set within predefined boundaries to keep the exchange rate value locked in. For example, in 1992, the UK withdrew from the Exchange Rate Mechanism. The result was a sharp reduction in interest rates that enabled the beleaguered U.K. economy to pull itself out of an overly long recession.
The floating exchange rate system is based on rates that fluctuate from one day to the next. When rates fluctuate significantly, the elements of instability and uncertainty cause problems for businesses engaged in trade. For example, a firm that relies on imported raw materials for production, devaluation of currency would mean an increase in import costs and lower profitability. Sellers also have a problem when changing exchange rates affect prices and consequently sales.
A floating exchange rate system can often cause inflation. Governments that allow exchange rates to devalue can cause inflationary pressures to occur, leading to instability in the market. A floating exchange rate does not in any way control inflation, rather it encourages it. One example would be inflation caused by floating rates that allows import prices to rise as exchange rates fall. This causes an imbalance in trade, especially for countries dependent on other countries for essential food and raw materials.