Examine the arguments for a freely floating exchange rate

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                Bianca René

“Floating Exchange Rates bring about equilibrium in the global economy.”

a) Examine the arguments for a freely floating exchange rate (50 marks)

An exchange rate system is a system, which determines the conditions under which one currency can be exchanged for another. A freely floating exchange rate system is where free market forces determine the value of a currency. In theory, governments through their central banks, are assumed not to intervene in the foreign exchange markets, however, governments in practice find it impossible not to intervene as exchange rates can lead to significant changes in domestic output, unemployment and inflation.

In theory, governments need not to intervene, as it is argued that freely floating exchange rates will automatically move to restore equilibrium on the current balance of the balance of payments. For example, if the current balance of the balance of payments in the UK was in a deficit, meaning that the value of imports exceeds the value of exports in that particular period, the demand for sterling pound will fall and the value of sterling demand for foreign currencies will rise. The external value of the pound would fall, making UK exports more price competitive and UK imports less competitive in the international market. Export sales therefore rise and import purchases fall, correcting the current balance deficit. The opposite occurs for a balance of payments surplus. However, the extent to which this occurs depends on the price elasticity of demand for exports and imports on the Marshall Lerner Condition. This condition states that devaluation (a fall in the value of the currency) will lead to an improvement on the current balance will be seen if the combined elasticities of demand for exports and imports are greater than 1. The size of any J-curve affect in the short run will also affect this extent. The J-curve effect is a short term effect where a devaluation is likely to lead to a deterioration in the current account position before it starts to improve. This happens because in the short run, demand for exports and imports tend to be inelastic. Although the foreign currency price of UK exports will fall, it takes time before other countries react to the change. So, in the volume exports will remain the same in the short term, before increasing in the long term.

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A country’s current account on the balance of payments may move into disequilibrium. Different exchange rate systems have different ways of returning the balance of payments back into equilibrium. The movement back often involves economic costs, such as increased unemployment, which can occurred under the Gold Standard System or lower economic growth, under the Bretton Woods System, both of which are examples of the fixed exchange rate system (a rate of exchange between at least two countries, which is constant over a period of time).

Freely floating exchange rates offer greater flexibility of trade, than other exchange rate ...

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