Handbook of Exchange Rates

28.3 Five Advantages of Floating Exchange Rates

As there are five advantages to fixed exchange rates, there are also five advantages to flexible exchange rates. They are (i) national independence for monetary policy, (ii) allowing automatic adjustment to trade shocks, (iii) retaining seigniorage, (iv) retaining lender-of-last-resort capability, and (v) avoiding speculative attacks.

The leading advantage of exchange rate flexibility is that it allows the country to pursue an independent monetary policy. The argument in favor of monetary independence, instead of constraining monetary policy by the fixed exchange rate, is the classic argument for discretion, instead of rules. When the economy is hit by a disturbance, such as a fall in demand for the goods it produces, the government would like to be able to respond so that the country does not go into recession. Under fixed exchange rates, monetary policy is always diverted, at least to some extent, to dealing with the balance of payments. This single instrument cannot be used to achieve both internal balance and external balance.

Under the combination of fixed exchange rates and complete integration of financial markets, which, for example, characterizes EMU, the situation is more extreme: monetary policy becomes altogether powerless to affect internal balance. Under these conditions, the domestic interest rate is tied to the foreign interest rate. An expansion in the money supply has no effect: the new money flows out of the country ...