Free Floating Exchange Rate: Advantages and Disadvantages

A free floating currency exchange rate is a widely-spread system that is used by many countries today. While globalization is in progress, more and more nations refuse from pegging currency. Instead, they make it possible for it to float freely and adapt to constantly changing economic conditions.

Some countries were forced to abandon currency pegs due to geopolitical and other conditions that are shaping the world differently. Others chose to favor a flexible exchange rate because of its major advantages. Of course, having a floating currency is not the ultimate solution for all nations. However, it definitely brings some crucial pros considering exchange rate fluctuation.

This article will highlight all the fundamental pros and cons of a free floating exchange rate.

Floating Exchange Rate Pros

As stated earlier, the floating currency is the mainstream today. Some nations were forced to adopt it while others made their choice because of obvious advantages in reference to their particular economic situation.

1. Rates Determined by the Market

Freely floating currency is associated with rates determined by the market, not by central banks or stronger nations with healthier economies. We will have a real-time exchange rate set by specific market conditions that are equal for all market participants. The rate may change depending on the news that is flowing in. On the other hand, the rate will always stay in a particular range.

Fixed exchange rates require the government and central banks many efforts to manage currency effectively. Oppositely, floating rates make it possible to manage currencies passively. All they need is to set major rates and interfere with the market only when the situation is critical.

2. A Greater Degree of Independence

If one country has a pegged rate, it has nothing to do but cooperate with a stronger nation and make crucial economic decisions in tandem. In case of free floating currency, central banks are more independent. All economic changes and decisions will hardly affect other member nations.

For example, a country has its currency pegged to USD. When the FED raises the interest rate, all pegged currencies will inevitably lose value. Meanwhile, central banks of pegged nations will have to take specific measures to improve the situation that will impact other member countries.

3. Fewer Speculative Attacks

Increasing speculative attacks are one of the main drawbacks of a fixed exchange rate. They happen when the currency keeps stagnant creating more opportunities for speculators. A free floating rate can adjust to changing economic conditions. What’s more, it happens in minutes, especially if an underlying currency is traded in the FOX market. So, the chances for speculative attacks are lower.

4. Milder Reserve Requirements

A free floating exchange rate means lower requirements on the nation’s reserves, as central banks are not forced to conduct multiple trading operations to keep control over the rate. In reality, they rarely express trading activity.

With a fixed rate, a country must have a round-the-clock trading desk. Besides, the more trading activity it has, the more reserves it will need to conduct operations. A few nations can afford it today.

Floating Exchange Rate Cons

Of course, the floating currency is not a perfect system. It has a number of critics, who highlight the following disadvantages. Some of them are very important to take into account.

1. Market Uncertainty

With a pegged rate, you always know what to expect. Businesses can plan their import and export costs. A free floating exchange rate comes with increased volatility. Besides, the currency value can change every minute.

As we know, the Forex market is not centralized or regulated. It means a free floating asset can skyrocket or hit the bottom in seconds. This fact creates specific challenges for Forex traders. They cannot predict exact prices even in a short-term perspective. It can lead to significant losses not only for traders but also for companies.

2. Resource Allocation

When a country tries to allocate resources, its economy is facing a problem. If an exchange rate changes, so do potential benefits that can be driven by available resources. A growing rate makes import a better option while export looks potentially better in a falling market. To avoid losses, nations usually plan resource allocation within a short timeframe.

3. Lacking Discipline

Last but not least, free floating rates will make sense only if a nation has a sufficient internal mechanism to keep control over economic health and react accordingly. It will never work if central banks misuse their monetary policy.

It usually happens in countries with soaring corruption, when a group of influential leaders misuses the monetary [policy in favor of their personal gains. This is when it is better to peg one nation’s currency to a stronger asset.

The Bottom Line

In reality, a free floating exchange rate provides enough freedom and flexibility for the nation to manage currencies. However, the model will make sense only in case of a well-organized monetary policy and disciplined economy.

For this reason, the majority of third-world nations used to peg their currencies to the world’s leading assets (USD, EUR), etc.). However, the situation is changing over the last few years. More and more nations are either forced or prefer to abandon pegged rates opting for freely floating currencies.

This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.