*** Welcome to piglix ***

Fear of floating


Fear of floating refers to situations where a country prefers a smoother exchange rate to a floating exchange rate regime. This is more relevant in emerging economies, especially when they suffered from financial crisis in last two decades. In foreign exchange markets of the emerging market economies, there is evidence showing that countries who claim they are floating their currency, are actually reluctant to let the nominal exchange rate fluctuate in response to macroeconomic shocks. In the literature, this is first convincingly documented by Calvo and Reinhart with "fear of floating" as the title of one of their papers in 2000. Since then, this widespread phenomenon of reluctance to adjust exchange rates in emerging markets is usually called "fear of floating". Most of the studies on "fear of floating" are closely related to literature on costs and benefits of different exchange rate regimes.

To understand the benefits and costs of floating a currency, we need to make a simple comparison between a floating exchange rate and a fixed (or pegged) exchange rate. A floating exchange rate refers to the situation when the currency's value is allowed to fluctuate according to the foreign exchange market. The value of this currency is determined by the supply and demand shocks in the market of the currency (foreign exchange market). Most of the countries adopting the free, floating exchange rate regimes (floaters) are developed small open economies, such as Canada, Australia, Sweden.

The basic debate between fixed and floating exchange rate regimes is mentioned in most principle of macroeconomics textbooks, where the Mundell–Fleming model is presented to explain the exchange rate regimes. Three, potentially desirous policies, are called "impossible trinity" because a country could not achieve all three at the same time.

Some economists believe, in most circumstances, floating exchange rates are preferable to fixed exchange rates. Firstly, giving up the fixed exchange rate could gain more flexibility in monetary policy. For some countries, inflation is the main policy target by the central bank. It is often true that a high degree of exchange rate flexibility would help inflation targeting to be more successful. Secondly, as floating exchange rates automatically adjust, they enable a country to dampen the impact of shocks and foreign business cycles, and to preempt the possibility of having a balance of payments crisis.


...
Wikipedia

...