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
