Pros and cons of a floating exchange rate system

In the F585 Summer 2014 case study, Latvia uses a fixed exchange rate system. Iceland operates a floating exchange rate system. So be sure to know the pros and cons of each system

Floating exchange rate benefits

• Automatic adjustment mechanism for any balance of payments disequilibrium
• Frees monetary policy to target alternative objectives instead of a fixed exchange rate
• Reduces need to hold foreign currency reserves – which have an opportunity cost

Floating exchange rate drawbacks

• uncertainty about future export and import prices may deter investment 
• encourages indiscipline if govt and firms rely on devaluation to restore competitiveness 
• Automatic BoP adjustment mechanism only works if demand is price elastic

Fixed exchange rate benefits

• Reduced exchange rate uncertainty so encouraging domestic investment and FDI 
• Should eliminate destabilising speculation 
• Reduced costs as no need to hedge 
• Imposes discipline on domestic firms

Fixed exchange rate drawbacks

• No automatic balance of payments adjustment as with a floating exchange rate
• Requires high levels of foreign currency reserves which have an opportunity cost 
• Reduced flexibility for monetary policy as interest rates are targeted at a stabilising the exchange rate rather than say inflation ie conflicting macro policy objectives
• Setting the 'wrong' exchange rate (where REER is >) 1 reduces international competitiveness and encourages speculative attacks

However countries seeking monetary union and its associated benefits within the EU must first adopt a fixed rate exchange rate system which helps explain why Latvia pegged its currency to the euro so as to be able to enter full monetary union in Jan 2014