Fixed And Floating Exchange Rates

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With reference to the UK economy, discuss the relative advantages and disadvantages of fixed and floating exchange rates. An exchange rate system is a system, which determines the conditions under which one currency can be exchanged for another. A freely floating exchange rate system is where free market forces determine the value of a currency. In theory, governments through their central banks, are assumed not to intervene in the foreign exchange markets, however, governments in practice find it impossible not to intervene as exchange rates can lead to significant changes in domestic output, unemployment and inflation. In theory, governments need not to intervene, as it is argued that freely floating exchange rates will automatically move to restore equilibrium on the current balance of the balance of payments. For example, if the current balance of the balance of payments in the UK was in a deficit, meaning that the value of imports exceeds the value of exports in that particular period, the demand for sterling pound will fall and the value of sterling demand for foreign currencies will rise. The external value of the pound would fall, making UK exports more price competitive and UK imports less competitive in the international market. Export sales therefore rise and import purchases fall, correcting the current balance deficit. The opposite occurs for a balance of payments surplus. However, the extent to which this occurs depends on the price elasticity of demand for exports and imports on the Marshall Lerner Condition. This condition states that devaluation (a fall in the value of the currency) will lead to an improvement on the current balance will be seen if the combined elasticities of demand for exports and imports are greater than 1. The size of any J-curve affect in the short run will also affect this extent. The J-curve effect is a short term
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