Assess the importance of a floating exchange rate
to a country trying to achieve macroeconomic
stability [25 marks]
A floating exchange rate is a system, in which governments allow the exchange rate to be
determined by the market forces of demand and supply. Though many countries have opted for this
system, including the UK, Canada and Nigeria, the alternate system is a fixed exchange rate, in which
governments keep the value of a currency fixed against another currency. As exchange rates play a
key role in macroeconomic stability, affecting the indicators of inflation, GDP and trade, the system a
country utilises is therefore significant.
Floating exchange rates may lead to an improvement in the
balance of trade if there is depreciation in the value of a
currency. A currency depreciation causes downward pressure
on export prices, making them more price competitive and
appealing to buyers on the foreign market. An increased net
export value, due to increased export demand, not only
reduces the current account deficit and improves the balance
of trade, but it also contributes to increased aggregate demand
and economic growth, as exports are a component of AD. This
is shown in diagram A through the outward shift of the AD
curve, from AD1 to AD2, and the expansion of national income, from Y1 to Y2. This increase in
economic growth is likely to contribute to a positive multiplier effect, which may have a wider
impact on the economy through the creation of new jobs, decreased unemployment and higher
disposable incomes for consumers, therefore creating stability in the indicators of GDP and
unemployment levels.
A floating exchange rate system can provide effective economic adjustment during periods of
volatility, as a currency depreciation is likely to increase export demand and stimulate aggregate
demand, therefore increasing GDP and improving the balance of trade. This is exemplified
in Canada’s use of a floating exchange rate, in which the exogenous shock of the 1990s Asian
financial crisis caused a decline in the economy’s export of commodities. The subsequent
depreciation of the Canadian dollar, though stagnating the commodity-related export market, led to
increased price competitiveness in non-commodity export sectors, which expanded the economy’s
overall export market and improved their trade balance. However, if a fixed exchange system was
used, then a contractionary monetary policy of increasing interest rates may have been needed to
prevent a further depreciation of the Canadian dollar. This may have further stagnated economic
growth as higher interest rates may have restricted the aggregate demand components of
consumption and investment, instead causing a negative multiplier effect. In this case, a floating
exchange rate helped to maintain Canada’s macroeconomic stability, despite the initial fall in export
demand, during a volatile period.
Another way in which floating exchange rates can improve macroeconomic stability is by allowing
the use of an independent monetary policy. As exchange rate targets do not need to be set by the
government in a floating exchange system, it allows the country’s central bank to manipulate
interest rates to meet domestic aims, like maintaining low inflation or stimulating economic growth.
During the 2008 Great Recession, the Bank of England reduced interest rates from 5% to 0.5%, in
order to stimulate aggregate demand through increased consumption and investment, and to move
the UK economy out of the recessionary stage in the business cycle. As a result, annual GDP growth
increased from -2.2% in 2008 Q4 to 0.4% in 2009 Q4, showing the impact of lowered interest rates in
to a country trying to achieve macroeconomic
stability [25 marks]
A floating exchange rate is a system, in which governments allow the exchange rate to be
determined by the market forces of demand and supply. Though many countries have opted for this
system, including the UK, Canada and Nigeria, the alternate system is a fixed exchange rate, in which
governments keep the value of a currency fixed against another currency. As exchange rates play a
key role in macroeconomic stability, affecting the indicators of inflation, GDP and trade, the system a
country utilises is therefore significant.
Floating exchange rates may lead to an improvement in the
balance of trade if there is depreciation in the value of a
currency. A currency depreciation causes downward pressure
on export prices, making them more price competitive and
appealing to buyers on the foreign market. An increased net
export value, due to increased export demand, not only
reduces the current account deficit and improves the balance
of trade, but it also contributes to increased aggregate demand
and economic growth, as exports are a component of AD. This
is shown in diagram A through the outward shift of the AD
curve, from AD1 to AD2, and the expansion of national income, from Y1 to Y2. This increase in
economic growth is likely to contribute to a positive multiplier effect, which may have a wider
impact on the economy through the creation of new jobs, decreased unemployment and higher
disposable incomes for consumers, therefore creating stability in the indicators of GDP and
unemployment levels.
A floating exchange rate system can provide effective economic adjustment during periods of
volatility, as a currency depreciation is likely to increase export demand and stimulate aggregate
demand, therefore increasing GDP and improving the balance of trade. This is exemplified
in Canada’s use of a floating exchange rate, in which the exogenous shock of the 1990s Asian
financial crisis caused a decline in the economy’s export of commodities. The subsequent
depreciation of the Canadian dollar, though stagnating the commodity-related export market, led to
increased price competitiveness in non-commodity export sectors, which expanded the economy’s
overall export market and improved their trade balance. However, if a fixed exchange system was
used, then a contractionary monetary policy of increasing interest rates may have been needed to
prevent a further depreciation of the Canadian dollar. This may have further stagnated economic
growth as higher interest rates may have restricted the aggregate demand components of
consumption and investment, instead causing a negative multiplier effect. In this case, a floating
exchange rate helped to maintain Canada’s macroeconomic stability, despite the initial fall in export
demand, during a volatile period.
Another way in which floating exchange rates can improve macroeconomic stability is by allowing
the use of an independent monetary policy. As exchange rate targets do not need to be set by the
government in a floating exchange system, it allows the country’s central bank to manipulate
interest rates to meet domestic aims, like maintaining low inflation or stimulating economic growth.
During the 2008 Great Recession, the Bank of England reduced interest rates from 5% to 0.5%, in
order to stimulate aggregate demand through increased consumption and investment, and to move
the UK economy out of the recessionary stage in the business cycle. As a result, annual GDP growth
increased from -2.2% in 2008 Q4 to 0.4% in 2009 Q4, showing the impact of lowered interest rates in
