What is a clean float?
A clean float, also known as a pure exchange rate, occurs when the value of a currency, or its exchange rate, is determined purely by supply and demand in the market. A clean float is the opposite of a dirty float, which occurs when government rules or laws affect the price of the coin.
- A clean float, in monetary systems, is when the exchange rate of a currency is determined solely by market forces.
- The variation in exchange rates is driven by supply and demand and by fundamental factors such as economic indicators and a nation’s growth expectations.
- In reality, it is difficult to maintain a clean float for long, as market forces can generate volatility and unexpected currency movements that are adverse to a nation’s economic activity.
Understanding clean floats
Most of the world’s major currencies exist as part of a floating exchange rate regime. In this system, the values of currencies fluctuate in response to movements in the currency markets. You may have noticed that when you travel to the Eurozone, for example, the amount of euros you can exchange for your dollars varies from trip to trip. This variation is the result of fluctuations in the currency markets.
Floating coins are in contrast to fixed money, which has a value based on the current market value of gold or another commodity. Floating coins can also float relative to another coin or basket of coins. China was the last country to use the fixed currency and abandoned it in 2005 for a managed monetary system.
There are clean floats where there is no government interference in currency exchange. Clean floats are the result of laissez-faire or the free market economy where the government places few restrictions on buyers and sellers.
Limitations of clean floats
In a perfect world, clean floats mean that the value of currencies adjusts automatically, leaving countries free to pursue domestic monetary goals such as controlling inflation or unemployment. However, a clean floating currency can be susceptible to external shocks, such as an increase in the price of oil, which can make it difficult for countries to maintain a clean floating system.
The genuine floating currency exchange can experience some volatility and uncertainty. For example, external forces beyond government control, such as geopolitical conflicts, natural disasters, or changing weather patterns that affect crops and exports, can influence currency prices. A government will tend to intervene to exert control over its monetary policies, stabilize its markets, and limit some of this uncertainty.
Short-term movements in a floating exchange rate currency reflect speculation, rumors, disasters, and daily supply and demand for the currency. If supply exceeds demand, that currency will fall, and if demand exceeds supply, that currency will rise. Extreme short-term movements can result in central bank intervention, even in a floating rate environment. Because of this, while most of the major world currencies are considered floating, central banks and governments can intervene if a nation’s currency becomes too high or too low.
Too high or too low a currency could negatively affect the nation’s economy, affecting trade and the ability to pay debts. The government or the central bank will try to implement measures to move their currency at a more favorable price.
This is why many of the world’s currencies only float up to a certain point and depend on some support from their corresponding central bank. These limited-scope floating currencies include the US dollar (USD), the euro, the Japanese yen (JPY), and the British pound (GBP).
Most countries step in from time to time to influence the price of their currency in what is known as a managed float system. For example, a central bank could let its currency float between an upper and a lower price limit. If the price moves beyond these limits, the central bank can buy or sell large amounts of currency in an attempt to control the price. Canada maintains a system that more closely resembles a genuine floating currency. The Central Bank of Canada has not intervened with the price of the Canadian dollar (CAD) since 1998. The United States also interferes relatively little with the price of the US dollar.
Floating vs. Fixed Exchange Rates
Currency prices can be determined in two ways: a floating rate or a fixed rate. As mentioned above, the floating rate is generally determined by the open market through supply and demand. Therefore, if the demand for the currency is high, the value will increase. If the demand is low, this will cause the price of the currency to go down.
The government determines a fixed or fixed rate through its central bank. The rate is set against another major world currency (such as the US dollar, euro, or yen). To maintain its exchange rate, the government will buy and sell its own currency against the currency to which it is pegged. Some countries that choose to peg their currencies to the US dollar are China and Saudi Arabia.
The currencies of most of the world’s major economies were allowed to float freely after the collapse of the Bretton Woods system between 1968 and 1973.