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 pricing of currency.
- A clean float, in monetary systems, is when a currency's exchange rate is determined solely by market forces.
- Variation in exchange rates is driven by supply and demand and fundamentals such as a nation's economic indicators and growth expectations.
- In reality, a clean float is difficult to maintain for long, as market forces can bring 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, currency values fluctuate in response to movements in foreign exchange 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 a result of the fluctuations in the foreign exchange markets.
Floating currencies sit in contrast with fixed money, which has a value basis on the current market value of gold or another commodity. Floating currencies may also float in relation to another currency or basket of currencies. China was the last country to use the fixed currency, giving it up in 2005 for a managed currency system.
Clean floats exist where there is no government interference in the exchange of currency. Clean floats are a result of laissez-faire or free-market economics where government places few restrictions on buyers and sellers.
Limitations of Clean Floats
In a perfect world, clean floats mean the value of currencies automatically adjusts, leaving countries free to pursue internal monetary goals such as controlling inflation or unemployment. However, a clean floating currency can be susceptible to external shocks, such as a spike in the price of oil, which can make it hard for countries to maintain a clean floating system.
Genuine floating currency exchange can experience a certain amount of 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 their monetary policies, stabilize their markets, and limit some of this uncertainty.
Short-term moves in a floating exchange rate currency reflect speculation, rumors, disasters, and everyday supply and demand for the currency. If supply outstrips demand that currency will fall, and if demand outstrips supply that currency will rise. Extreme short-term moves can result in intervention by central banks, even in a floating rate environment. Because of this, while most major global currencies are considered floating, central banks and governments may step in if a nation's currency becomes too high or too low.
A currency that is too high or too low could affect the nation's economy negatively, affecting trade and the ability to pay debts. The government or central bank will attempt to implement measures to move their currency to a more favorable price.
That’s why many of the world’s currencies are only floating to a certain extent and rely on some support from their corresponding central bank. These limited extent floating currencies include the US dollar (USD), the euro, the Japanese yen (JPY), and the British pound (GBP).
Most countries intervene 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 might let its currency float between an upper and lower price boundary. If the price moves beyond these limits, the central bank may buy or sell large lots of currency in an attempt to rein in the price. Canada maintains a system that most closely resembles a genuine floating currency. The Canadian Central Bank has not intervened with the price of the Canadian dollar (CAD) since 1998. The US also interferes relatively little with the price of the American 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 usually determined by the open market through supply and demand. Therefore, if the demand for the currency is high, the value will increase. If demand is low, this will drive that currency price lower.
A fixed or pegged rate is determined by the government through its central bank. The rate is set against another major world currency (such as the U.S. 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 U.S. dollar include China and Saudi Arabia.
The currencies of most of the world's major economies were allowed to float freely following the collapse of the Bretton Woods system between 1968 and 1973.