Floating exchange rates ensure balance-of-payments...

Floating exchange rates ensure balance-of-payments equilibrium

Proponents of floating exchange rates argue that in a floating regime the exchange rate automatically adjusts to ensure continuous equilibrium between the demand for, and supply of, the currency.If a country is running an unsustainable current account deficit, its exchange rate will depreciate which will reduce imports and increase exports until the balance of payments is restored to a sustainable level.Conversely, a structural surplus in the balance of payments will lead to an exchange-rate appreciation that will reduce the surplus to sustainable levels.

In other words, floating exchange rates ensure a balance between the demand for the supply of a currency; excess demand leads to appreciation, whereas excess supply leads to depreciation.This contrasts to the scenario under fixed exchange rates where an overvalued rate leads to an excess supply and thereby a fall in the authorities’ reserves, while fixing it at an undervalued rate leads to excess demand and an increase in their reserves.Even if by chance the authorities initially peg the exchange rate at the point where supply equals demand, that rate will soon become inappropriate when a change in the economic fundamentals affects the supply or demand for the currency.Exchange-rate adjustments by taking care of the balance-of-payments deficits relieve the authorities of having to adopt unpopular alternatives such as deflation or a restore to protectionism which could then provoke a damaging trade war.