Floating exchange rates insulate economies

Floating exchange rates insulate economies

A further argument put forward in favor of floating exchange rates is that they can insulate the domestic economy from foreign price shocks.If there is an increase in foreign prices under floating exchange rates, provided the exchange rate moves roughly in line with PPP the domestic currency would merely appreciate so preventing the country from importing foreign inflation.This contrasts to what happens under fixed exchange rates where a foreign price rise makes the home economy over competitive, leading to a balance-of-payments surplus which necessitates purchases of the foreign currency with newly-created domestic currency to peg the exchange rate.The increase in the domestic money supply leads to an accompanying rise in domestic prices ending the surplus.Hence, fixed exchange rates lead to the importing of foreign price inflation/deflation.