Reference no: EM132529930

1. A floating exchange rate system establishes a currency's rate relative to other currencies. There are many advantages of a floating exchange rate. First, there is a balance of payments stability. Imbalances in the balance of payments usually lead to changes in exchange rates. For example, if there was a deficit in the balance of payments this would trigger a depreciation in currency. And this would make a country's exports cheaper in foreign markets, which would increase their demand and ultimately restoring equilibrium in the balance of payments. Second, there are no limitations on foreign exchange and capital flows. Third, it is not necessary to keep large foreign currency reserves because they won't need large amounts of foreign currency reserves to defend the exchange rate. In turn those reserves, could be used to import capital goods in order to promote economic growth. Lastly, it can protect against imported inflation.

The disadvantages of a floating exchange are a high level of exposure to exchange rate volatility and a lack of currency control which can limit economic growth or recovery. Naturally, the floating exchange rates are volatile and likely to have sharp fluctuations. The value of a currency in contrast to another reduce immensely in a day. Negative exchange rate movements for a country's currency can produce serious problems. For example, if the pound were to rise against the Euro, it will make exporting to the Eurozone from the UK very tough.

An alternative system can be to bring the currency under a fixed exchange rate system. It is also sometimes called a pegged exchange rate. A fixed exchange rate ties the country's currency official exchange rate to another's country's currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency's value in a limited range. Fixed rates offers better assurance for exporters and importers. And it also helps the government maintain a low inflation, which, in the long run, keeps the interest rates low and increases trade and investment.

2. One of the advantages inherent to a floating exchange rate system is the fact that the main determinant in the rate values are market forces. This allows for complete flexibility as the exchange rate value adjusts on a continual basis to changes in supply and demand. Such a system allows a country to be more insulated, or less effected by inflation of other countries. If the US experiences high inflation rates, then another country with whom they trade with, such as the UK, will purchase less goods since the value of the pound is worth less in comparison to the dollar that it was before. The pound will consequently appreciate in value in comparison to the dollar, which will cause goods from the UK to appear more expensive to the US when in fact the price has not risen, but a great number of US dollars is required to make the purchase due to the dollars inflation. This allows for an advantage to the UK, but a clear disadvantage in the system for the US as goods purchased from the UK will require more dollars to purchase. Under a fixed rate system, government intervention would allow the US to purchase goods from another nation to avoid the increase in price due to the countries own inflation.

Similarly, poor unemployment rates in one country have less effect on other countries. If the US were to lower the amount of goods purchased from the UK due to economic uncertainty, the demand for the British pound would decrease as well to the US. This could cause the dollar to appreciate to the pound, which will make goods from the UK require a lower number of US dollars to purchase. But this also creates a disadvantage for the country where unemployment is high as foreign goods will be purchased at a far greater rate than domestic goods do to the lower price, or lower amount of dollars required to make the purchase. Under a fixed rate system, the UK government would intervene in a way to maintain the value of the pound even if the US were to lower the number of goods, they purchased from them. The US government would also intervene be offering incentives to domestic manufacturers.

An alternative system that might be better suited to manage the present world economy is the pegged exchange rate system. Under this system, a countries exchange rate value is "pegged" a foreign nations currency or to an index of currencies. Many countries peg their currency to the US dollar as a means of stabilizing that countries exchange rate since the US dollar is a stable currency. This allows the foreign nations currency to "move against non-dollar currencies to the same extent as the dollar does.2" If more countries were to employ the pegged exchange rate system, the economies of these nations would move in conjunction with one another.