ABSTRACT

A system of freely floating exchange rates is characterised by: an exchange rate which fluctuates freely in response to changes in the demand for and supply of foreign exchange; balance of payments adjustment principally through exchange rate and interest rate changes, and the absence of international reserves of gold and foreign exchange. The implication of this is that floating exchange rates will be more volatile than fixed exchange rates since official intervention will not dampen the effects of exchange rate oscillations. Balance of payments adjustments under floating exchange rates can occur on current account, capital account, or both. Floating exchange rates may encourage stabilising speculation which limits the size of exchange rate fluctuations. Floating exchange rates might represent a second-best option in relation to the social benefits arising from fixed exchange rates and the establishment of an optimal currency area.