Floating Exchange Rate: Explained

The correct answer is option 'D', a floating exchange rate. Let's understand why.

Definition of Floating Exchange Rate:
A floating exchange rate, also known as a flexible exchange rate, is a type of exchange rate regime where the value of a country's currency is determined by the market forces of demand and supply, without any intervention from the government or central bank.

Factors Influencing Floating Exchange Rates:

1. Market Forces of Demand and Supply:
Under a floating exchange rate regime, the exchange rate is primarily determined by the interaction between the demand for and supply of a currency in the foreign exchange market. The exchange rate adjusts automatically to reflect changes in these market forces.

2. Demand for Currency:
The demand for a currency is influenced by multiple factors, including:

- Trade Balance: If a country has a trade surplus (exports exceed imports), there is a high demand for its currency as foreigners need to buy that currency to pay for the country's exports.
- Interest Rates: Higher interest rates in a country attract foreign investors, leading to an increased demand for its currency.
- Economic Performance: A country with strong economic growth and stable political conditions tends to attract more foreign investment, resulting in a higher demand for its currency.
- Speculation: Currency traders often speculate on future exchange rate movements, which can influence the demand for a particular currency.

3. Supply of Currency:
The supply of a currency is influenced by factors such as:

- Trade Balance: If a country has a trade deficit (imports exceed exports), it needs to supply its currency in the foreign exchange market to obtain foreign currencies for paying for imports.
- Capital Flows: Inflows of foreign capital into a country increase the supply of its currency, while outflows of capital decrease the supply.
- Monetary Policy: Central banks can influence the supply of currency through various monetary policy measures, such as open market operations and changes in interest rates.

Advantages of Floating Exchange Rates:

1. Market Efficiency:
Floating exchange rates allow currencies to adjust freely, which helps maintain equilibrium in the foreign exchange market. This allows market forces to efficiently determine the exchange rate based on the supply and demand conditions.

2. Absence of Speculative Attacks:
Under a floating exchange rate regime, speculative attacks on a currency are less likely as the exchange rate is flexible and adjusts to market conditions. This reduces the risk of currency crises and the need for central bank interventions.

3. Monetary Policy Autonomy:
Floating exchange rates provide more flexibility to central banks in conducting independent monetary policies. They can adjust interest rates and implement other measures to stabilize the domestic economy without worrying about maintaining a fixed exchange rate.

Conclusion:
A floating exchange rate is a market-determined exchange rate regime where the value of a currency is determined by the forces of demand and supply. It offers advantages such as market efficiency, reduced risk of speculative attacks, and increased monetary policy autonomy.