Floating Exchange Rates are basically exchange rate regimes that allow exchange rates to go up and down according to the changes of demand and supply
This can be shown by the diagram below :
As we see from the diagram this is an example of supply movements in a floating exchange rates where the supply of UK sterling has increased therefore leading to a DEPRECIATION.
The Advantages of a Floating Exchange Rates:
- Firstly that there is continuous and automatic adjustment as the foreign exchange rate market changes the rates automatically to reflect the purchasing power of one currency against another. Does not really require any government intervention.
- Reducing Speculative Pressure: Under fixed exchange rates this had allowed speculators to sell its currency hoping to repurchase when its price has fallen. This is as governments would have to lower the value of the currency and allowing the speculators to gain. However with FLOATING there is normally an advantage as speculators does not know how far the government would allow the currency to fall so there is a high degree of uncertainty so it reduces the destabilising effects of speculation.
- Reduction of large foreign exchange reserves: Government no longer have to maintain the level of a fixed exchange rate.
- No Guarantee a drop would lead to the solve balance of payments problems as it also depends on the elasticity of demand for imports and exports.
- Effect on Domestic Inflation – if a currency increase in value( appreciates) this could cause cost push inflation such as domestic firms may have to pay more for its raw material from abroad. Firms are likely to raise their prices.
- Uncertainty- There would be a high level of capital flows because the currency can trade with all the currencies due to the removal of exchange controls. This could lead to uncertainty as the domestic currency could rise dramatically against other currencies and might lead to higher export prices.May lead to unemployment in these export sectors.
- Foreign Currency Reserve may still be in use as the government may still buy and sell the currency so it is at its optimal value.