A potential disadvantage of freely floating exchange rates is that there would:
A) Exist excessive amounts of hedging in the foreign exchange markets
B) Be a lack of incentive to initiate exchange arbitrage
C) Be excessive amounts of destabilizing speculation
D) Exist a devaluation bias in the exchange markets

Question

Quizplus · Accepted Answer

Freely floating exchange rates can lead to excessive amounts of destabilizing speculation, as market participants may attempt to profit from short-term fluctuations in currency values. This can lead to increased volatility and uncertainty in the foreign exchange markets, which can be detrimental to businesses and investors that rely on stable exchange rates for planning and decision-making. Option A is unlikely to be a disadvantage of freely floating exchange rates because hedging is a common practice in foreign exchange markets regardless of the exchange rate regime. Option B is also unlikely to be a disadvantage because exchange arbitrage is still profitable even when exchange rates are freely floating. Option D is not a commonly recognized disadvantage of freely floating exchange rates, as devaluation can occur in either fixed or floating exchange rate regimes depending on a country's economic policies and circumstances.

A Potential Disadvantage of Freely Floating Exchange Rates Is That