The good and bad of free float.
According to unconfirmed reports, a free float of the rupee is said to be an essential IMF conditionality for approving a bailout for us. If we accept this conditionality, what is likely to happen to our economic well-being? There is no clear-cut answer.
Over the years, economists and politicians have often changed their minds about whether it is a good idea to try to hold a country's exchange rate steady, rather than let it be decided by market forces. For two decades after the World War II, many of the major currencies were fixed under the Bretton Woods Agreement.
During the following two decades, the number of currencies allowed to float increased, although in the late 1990s a number of European currencies were permanently fixed under Economic and Monetary Union and some other countries established currency boards.
When capital can flow easily around the world, countries cannot fix their exchange rate and at the same time maintain an independent monetary policy. They must choose between the confidence and stability provided by a fixed exchange rate and the control over interest rate policy offered by a floating exchange rate.
On the face of it, in a world of capital mobility a more flexible exchange rate seems the best bet. A floating currency will force firms and investors to hedge against fluctuations. It should make foreign banks more circumspect about lending. At the same time it gives the policy makers the option of devising their own monetary policy.
But floating exchange rates have a big drawback: when moving from one equilibrium to another, currencies can overshoot and become highly unstable, especially if large amounts of capital flow in or out of a country, perhaps because of speculation by investors. This instability has real economic cost. To get the best of both the worlds, many emerging economies have tried a hybrid approach, loosely tying their exchange rate either to a single foreign currency, such as the dollar, or a basket of currencies.
But the currency crisis of the late 1990s, and the failure of Argentina's currency board, led many economists to conclude that if not a currency union such as the euro, the best policy may be to have free-floating exchange rate (EconomicsAn A-Z Guide by Mathew Bishop, pages 111-112).
Advantages of free float as per other sources: floating exchange rates don't require an international manager like IMF to look over current account imbalances. Under this system, if a country has large current account deficits, its currency depreciates; central banks frequently must intervene in foreign exchange markets under the fixed exchange rate regime to protect parity, but such is not the case under the floating regime.
Here there's no parity to uphold; in a floating exchange rate regime, the macroeconomic fundamentals of countries affect the exchange rate in international markets which, in turn, affect portfolio flows between countries. Therefore, floating exchange rate regimes enhance market efficiency; under a fixed exchange rate regime, countries export their macroeconomic problems to other countries.
Suppose that the inflation rate in the US is rising relative to that of the Euro-zone. Under a fixed exchange rate regime, this scenario leads to an increased US demand for European goods which then increases the Euro-zone's price level. Under a floating exchange rate system countries are more insulated from other countries' macroeconomic problems.
Disadvantages: floating exchange rates are highly volatile. Macroeconomic fundamentals can't explain especially short-run volatility in floating exchange rates; higher volatility in exchange rates increases the exchange rate risk that financial markets face. Therefore, they allocate substantial resources to predict the changes in the exchange rate, in bid to manage their exposure to exchange rate risk; floating exchange rates may aggravate existing problems in the economy.
If the country is already experiencing economic problems such as higher inflation or unemployment, floating exchange rates may make the situation worse. If the country suffers from higher inflation, depreciation of its currency may drive the inflation rate higher because of increased demand for its goods; however, the country's current account may also worsen because of more expensive imports.