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A key component of stable economic growth is a stable currency exchange rate. In recent times, there has been a debate about the economic benefits of fixed and floating exchange rates. One advantage of floating exchange rates is that it frees the macroeconomic policy from taking care of the exchange rate (Belghitar et al., 2016). Under this system, a country can rectify its balance of payments deficit by shifting its external currencys price. In that case, the domestic economy is buffered from foreign demand and supply changes because of the possibility of automatic adjustment. Hence, the government becomes free to focus its monetary policy on steadying the economy to respond to the above-mentioned external changes (Belghitar et al., 2016). Although the macroeconomic policy is freed from taking care of the exchange rate by a floating exchange rate, this argument is the weakest because it works against the exchange rate in some instances.
One major drawback of floating exchange rates is that currencies become highly unstable and overshoot when moving from one equilibrium to another. According to Belghitar et al. (2016), this shift is inevitable, especially when there is speculation from investors, which causes large amounts of capital flow in and out of the country. This instability of currencies has a significant economic effect on a country. To ensure a balance between both floating and fixed exchange rates, emerging economies should adopt a hybrid approach; a combination of the two. An easy flow of capital around the world makes it challenging for an economy to maintain an independent fiscal policy and fix its exchange rates (Belghitar et al., 2016). Therefore, the freedom that floating exchange rates offer to the macroeconomic policy works against it since it becomes hard for the economy to adjust to the free flow of capital.
Reference
Belghitar, Y., Clark, E., & Mefteh-Wali, S. (2016). The effect of floating exchange rates on SME performance [PDF document]. Web.
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