IGNOU : M.COM : IBO 6 : UNIT 1 : Q - 1. Is a floating-rate system move inflationary than a fixed rate system ? Explain.

Ans. The impact of floating rates in practice has bee; to increase uncertainty and misalignment ("overshooting") in foreign exchange markets. Overshooting implies that exchange rates move significantly beyond the equilibrium level. Markets for financial assets, including foreign exchange, react more quickly than markets for goods to financial disturbance or policy changes. Foreign exchange markets tend to be more volatile than other markets. Thus real exchange rate volatility has increased, not decreased since floating began.

Three variables determine the exchange rates; difference in price performance and in interest rates, movement of current account balances, and the expectations about future exchange rates engendered by these variables: There is a growing recognition of the importance of current account balances in influencing exchange rates.

Given this recognition a number of economists have called for a return to fixed exchange rates. They suggest to restrict more tightly the types of monetary and other policies governments can pursue and put a premium on avoidance of current account imbalances. It is argued that this should make expectations less volatile and reduce fluctuations in the real exchange rate.

The present state regarding the exchange rate practices of IMF members includes various alternatives from-pegging to floating.

Pegged exchange rates are managed on a day-to-day basis through official intervention in foreign exchange markets. Some countries are pegging their currencies to a group of currencies.

Floating exchange rates are managed less closely. Generally, nations with developed financial markets prefer to float their currencies. However, they do manage their currencies informally or rely on a co-operative exchange rate agreement such as the European Monetary System. Some countries 'lean against the wind' by official interventions to smooth short-term fluctuations in exchange rates. Some countries use target rates or objective indicators to provide signals for a devaluation or a revaluation of their currencies.