Most of the countries adopting the free, floating exchange rate regimes (floaters) are developed small open economies, such as Canada, Australia, Sweden.
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.
Most monetary authorities in emerging market economies have two implicit targets, they aim to maintain a low inflation while also avoiding large currency movements.
[3] Central banks in emerging economies will usually intervene to stabilize the currency when there is too much fluctuation in a short time period by using policy instruments.
To find out empirical statistics to assess this phenomenon, we could consider some countries with relatively pure floating regimes as benchmark cases, for example United States and Japan.
After calculating the monthly variation in percentage for developing countries in data sample, Calvo and Reinhart constructed a statistic to measure the flexibility of exchange rate.
[8] There also is evidence that the predominance of foreign currency liabilities in the banks’ balance sheets in Turkey induces a selling pressure in the exchange market as well as a fear of floating.
In countries with significant currency mismatches, the balance sheet effect is quite substantial, ignoring the high exchange rate volatility can prove to be very costly.
International transaction costs, network externalities, lack of credible domestic policies and underdeveloped local bond market are claimed to be the main reasons to the original sin.
For example, some economists find strong evidence of how relative price volatility affect sectoral allocation of investment away from what total factor productivity (TFP) differences would indicate.
Another main reason for fear of floating arises from the combination of lack of credibility, a high pass-through from exchange rates to prices and inflation targeting.
Calvo and Reinhart present a simple model to show "fear of floating" is attributed to lack of credibility and inflation targeting.
[14] The term "fear of floating" has been mainly used to describe intervention in foreign exchange market to avoid sudden or large depreciation.
One typical example is the debate on undervalued Chinese currency,[15] RMB and the huge foreign reserve accumulated from trade surplus.
A large number of scholars and policy makers examine whether this "fear of appreciation" has a positive impact on growth performance in developing economies.
Some economists show that depreciated exchange rates appear to induce higher growth, but that the effect works largely through the deepening of domestic savings and capital accumulation, rather than through import substitution or export booms as argued by the mercantilism view.
[16] They develop a model showing that foreign reserve accumulation by currency under-devaluation could be a second-best policy in economies with learning-by-investing externality.
So the previous reasons for fears of floating might make the idea of common currency area more alluring to the would-be entrants of the euro zone.
[18] For these countries in Europe, since there is long border, heavy trade and industry links with the euro zone, it is extremely difficult to control the capital flows.
In principle, floating exchange rates adjust automatically to keep economy in balance, but in real practice, these fluctuations would sometimes veer wildly from the ideal level.
By quitting the euro area, the central Bank of Greece regains exchange rate as a policy instrument to reduce the huge current account deficit.
[21] One possible solution is an intergovernmental treaty to put strict caps on government spending and borrowing relative to the current year GDP.