Floating exchange rate systems for small countries

¶ … Floating Exchange Rate System

For many developing countries, the exchange rate will have an impact on their ability to export products and services. While at the same time, there will be an effect on the total amounts of imports that are coming into a particular region. This is challenging as certain polices will have an influence on inflation, trade surpluses / deficits, interest rates and foreign direct investment capital. The combination of these factors will control the underlying amounts of economic growth and a nation's ability to compete in the global marketplace. (Gregio, 2004)

In the case of smaller countries, this can affect how their economy develops and unemployment levels. To fully understand the impact of currency moves requires examining if a floating rate system will help them to achieve their longer term objectives. This will be accomplished by providing recommendations that can help these nations to make the right decisions. Together, these elements will highlight the benefits and drawbacks of the floating exchange rate system.

Recommendations when establishing a floating exchange rate

One of the biggest factors when implementing any kind of floating exchange rate system is to have tremendous amounts of flexibility. This is because all central banks have the option of intervening in the Forex markets (which can influence prices). Those nations that do not stick to this kind of policy are engaging in tactics that could artificially manipulate the price of their currency. This makes it harder to address issues such as trade imbalances and inflation. As a result, those nations that are embracing these tactics will be more effective in maintaining balanced growth. (Gregio, 2004)

A good example of this can be seen by looking no further than Chile in the late 1990s. What happened is the country had been continually focusing on a managed reserve system. This created problems with inflation and it caused the nation to experience run away trade deficits. However, once the floating rate system was implemented, there was a decrease in inflation and unemployment. This helped Chile to experience strong demand for imports and it kept whole sale / retail prices in check. One of the keys to their success was the fact that the central bank utilized flexibility when intervening in the Forex markets. This allowed the country to go through strong periods of stable economic growth and quickly adjust to new challenges in the global economy. (Gregio, 2004)

At the same time, the government must enact policies that will help to support responsible growth. This means that issues such as corruption, crime, inflation, the total amounts of government spending, interest rates and trade figures will influence the prevailing rates in the market. These factors can affect the confidence of traders, investors and ratings agencies. (Walker, 2002)