Floating Exchange Rate

An exchange rate which is determined solely by the market forces of supply and demand.

Benefits

• Reduced need for currency reserves
  • No target exchange rate so no need for central bank to hold large reserves
• Partial correction for a trade deficit
  • Floating exchange rates can help when the balance of payments is in disequilibrium. In a large C/A deficit it applies downward pressure on the exchange rate

Factors that impact the value

• Base Rate
• The demand for imports and exports
  • High exports -> demand shifts right, value increases
  • High imports -> supply shifts right, value decreases
• Inflation -> Increases demand for imports as domestic goods are becoming expensive

Partial correction of C/A deficit

A current account deficit in simple terms means that Imports > Exports.
This means that there is a large supply of £ since UK companies sell the pound to buy foreign currencies.
This means that the value of the £ will drop, which in turn makes exports more competitive, helping to balance out the C/A deficit. This is the partial correction.

Depends upon

Partial correction of C/A deficit will only work when imports and exports are elastic.

This is known as the Marshall-Lerner Condition - The value of net export's elasticity must be greater than 1 in order to benefit from devaluation of the ER.

Elastic Scenario

£1 = $1.80 -> £1 = $1.60

Exports - Increase in quantity and value since they are more competitive

Imports - Decrease in quantity and value since they are more expensive

Therefore, C/A deficit improves

Inelastic Scenario

£1 = $1.80 -> £1 = $1.60

Exports - Stays similar, inelastic means no benefit from being more competitive

Imports - Get more expensive, but inelastic, so quantity stays similar.

Therefore, C/A deficit worsens