Free,
fluctuating or floating exchange rates means that the price of one currency in
terms of another is determined by the forces of supply and demand operating without any official interference.
The main advantage is that it provides a kind of automatic mechanism for keeping the balance of payments in
equilibrium. Secondly it stops
the exchange rate being a target, so government will not have to
introduce measures to protect the value of the currency at a fixed rate which
might threaten its other objectives.
A
major disadvantage of free or
floating rates is that they add a further element of uncertainty to international trading. The traders have to
accept a high degree of risk – they have to watch the foreign price of the
commodity and the price of the foreign currency. [Forward market reduces this
risk – They will a quote a fixed price for foreign currencies for future
delivery.]
A
fall in the value of the exchange rate will have the following effects
1,
it make exports less expensive, [lowering of export prices may increase exports
which may raise export revenue].
2, imports more expensive [if the demand
for both is price elastic, this should increase the demand for exports] this
will in turn
3, decrease the demand for imports and
4, encourage production of
exports and thereby
5, an increase employment. It will also
encourage production of domestic goods to replace the imports [the PED,
however, may not be elastic] As a result higher export revenue and lower import
expenditure will improve the trade position.
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