A flexible exchange rate system is a monetary regime in which the central bank allows the exchange rate to move freely without intervention. Supply-demand the currency, including speculation, determines the exchange rate.
Determinants of flexible exchange rate
Domestic currency demand and supply depends on some factors, including:
- Inflation rate
- Interest rate
- Trade balance
- Speculation activity
- Economic growth
- Government debt
A higher level of domestic inflation makes domestic goods prices more expensive for foreign buyers. Hence, they are uncompetitive in the international market. The demand for domestic goods decreases and resulted in a decline in exports. A decrease in exports reduces demand for the domestic currency, depreciating its value relative to trading partners’ currencies.
The spread fluctuation of domestic interest rates and international interest rates affect investment behavior. When spreads widen due to rising domestic interest rates, investors will go in to pursue higher returns. Capital inflows cause demand for the domestic currency to increase, encouraging its appreciation.
Conversely, when the spread narrows due to a decrease in domestic interest rates, capital flows out as investors seek higher returns abroad. As a result, the domestic currency depreciates.
Exports represent a demand for the domestic currency as foreign buyers need to convert their money to pay domestic goods. Conversely, imports represent a demand for trading partner’s currencies because domestic consumers must pay for imported products.
Therefore, when exports are higher than imports (trade surplus), the national exchange rate is likely to appreciate against the currencies of trading partners. The opposite effect applies when the economy experiences a trade deficit.
Advantages and disadvantages of flexible exchange rate
Flexible exchange rates allow for fully independent domestic policies. The foreign policy does not bind the central bank in implementing its monetary policy.
Flexible exchange rates do not require vast foreign exchange reserves. That contrasts with the fixed exchange rate, where the central bank requires sizeable foreign exchange reserves to intervene in the foreign exchange market. Considerable foreign exchange reserves reflect credible interventions.
In theory, flexible exchange rates allow exchange rates to move toward their equilibrium or fundamental. Take the case when a country runs a trade deficit. The deficit leads to a depreciation of the domestic currency. Furthermore, as a result of depreciation, domestic goods become cheaper for foreign buyers, and imported products become more expensive for domestic consumers. As a result, imports fall and exports rise, encouraging appreciation in the domestic exchange rate. Thus, the market mechanism works to direct the exchange rate toward its level of equilibrium.
However, flexible exchange rates make it difficult to achieve economic stability. Because there is no intervention, the exchange rate tends to fluctuate. They can move quickly, even if it is only due to a small speculation activity. Speculation could cause economic instability and also leads to the financial crisis, as happened in Indonesia in 1997.