ACCA Financial Management (F9) Certification Practice Exam

What does a government do to maintain a floating exchange rate?

1. Establishes a fixed price for the currency

2. Intervenes regularly in the foreign exchange market

3. Allows the currency value to fluctuate based on market forces

4. Imposes strict controls on currency trading

The correct answer is: Allows the currency value to fluctuate based on market forces

A government maintaining a floating exchange rate allows the currency value to fluctuate based on market forces. In a floating exchange rate system, the value of the currency is determined by supply and demand dynamics in the foreign exchange market without direct intervention from the government or central bank. This approach provides several benefits. It can adjust to economic conditions and respond to changes in trade balances, inflation, and interest rates naturally, allowing for greater flexibility. Furthermore, it helps avoid the potential inefficiencies associated with a fixed exchange rate, which may require constant adjustments or interventions to maintain a specific value. Measures such as regularly intervening in the foreign exchange market or imposing strict controls on currency trading are typically associated with either a fixed or managed exchange rate system rather than a floating one. In contrast, establishing a fixed price for the currency contradicts the principles of a floating exchange rate as it removes the influence of market forces on the currency’s value. Therefore, recognizing that a floating exchange rate relies on market mechanisms is crucial in understanding how currency values behave in such systems.