Question : What is the primary advantage of a floating exchange rate system?

Option 1: Stability in currency values
  

 

Option 2: Fixed exchange rates
 

Option 3: Flexibility in adjusting to market forces

  

Option 4: Controlled inflation rates

Correct Answer: Flexibility in adjusting to market forces

Solution : The correct answer is c) Flexibility in adjusting to market forces

The primary advantage of a floating exchange rate system is the flexibility it provides in adjusting to market forces. In a floating exchange rate system, the value of a currency is determined by market supply and demand. It fluctuates freely based on various factors such as economic conditions, interest rates, inflation rates, trade balances, and investor sentiment.

The flexibility of a floating exchange rate system allows currencies to adjust to changing economic conditions and market dynamics. Here are some key advantages associated with a floating exchange rate system:

1. Market-driven: Floating exchange rates reflect market forces, including supply and demand for currencies. This enables the exchange rate to more accurately reflect the economic fundamentals of a country, such as its productivity, inflation, and trade balances.

2. Automatic adjustments: Floating exchange rates can automatically adjust to changes in economic conditions. If a country experiences a trade deficit, for example, its currency may depreciate, making its exports more competitive and potentially reducing the deficit. This automatic adjustment mechanism helps restore balance in international trade.

3. Policy independence: A floating exchange rate system allows countries to have greater flexibility in conducting their own monetary and fiscal policies. They can adjust interest rates and implement other measures to address domestic economic objectives without being constrained by the need to maintain fixed exchange rates.

4. Market efficiency: Floating exchange rates encourage market participants to engage in currency hedging and risk management strategies, leading to more efficient allocation of resources and investments. It allows market participants to respond to changing economic conditions and profit from currency fluctuations.