Describes Clean float and Dirty float of foreign exchanges rates, Difference between Clean float and dirty float

Clean float and dirty float are terms used to describe different exchange rate regimes and practices related to currency valuation and management. Here’s an explanation of each:

Clean Float: Clean Float, also known as a freely floating exchange rate refers to a situation where the exchange rate is determined purely by market forces of supply and demand without any intervention or control by government or central bank. Under a clean float system, the exchange rate fluctuates freely in response to economic factors such as inflation, interest rates, trade balances, capital flows, and market speculation. The government or central bank does not actively intervene in the foreign exchange market to influence the exchange rate. The exchange rate is solely determined by the interactions of buyers and sellers in the market.

Advantages of clean float:

·        Reflects market forces and economic fundamentals.

·        Allows for automatic adjustments to change in supply and demand.

·        Reduce the need for frequent intervention by the central bank.

·        Enhances market efficiency and transparency.

Disadvantages of clean float

·        Exchange rate volatility can create uncertainty for business and investors.

·        May lead to speculative movements and sudden exchange rate fluctuations.

·        Can affect import/export competitiveness due to unpredictable exchange rate movements.

Dirty Float: Dirty float, also known as a managed float or a floating exchange rate with intervention, is a system where the exchange rate is predominantly determined by market forces but with occasional intervention by the government or central bank may intervene in the foreign exchange market by buying or selling its currency to stabilize or manage the exchange rate within a certain range or to address specific economic objectives.

Intervention in the foreign exchange market can be done through various measures:

Direct intervention: The central bank actively buys or sells its currency in the foreign exchange market to influence the exchange rate.

Indirect intervention: The central bank may implement policies such as interest rate adjustments, capital controls, or reserve requirements to influence capital flows and indirectly impact the exchange rate.

Advantages of dirty float:

·        Allows some level of exchange rate stability and control

·        Provides a buffer against excessive exchange rate volatility

·        Can help manage external shocks and maintain competitiveness

·        Supports specific economic objectives, such as controlling inflation or promoting exports.

Disadvantages of dirty float:

·        Government or central bank intervention can create moral hazard and distort market signal

·        The timing and effectiveness of interventions can be challenging to determine.

·        Intervention may deplete foreign exchange reserves if not managed prudently

·        Can lead to conflicts or disputes with trading partners if perceived as currency manipulation

 

It is important to note that the distinction between clean float and dirty float is not always clear-cut as exchange rate regimes can lie on a spectrum between fully fixed and fully floating. Some countries may also adopt hybrid systems or make occasional interventions even within a clean float framework, depending on their specific economic circumstances and policy objectives.

Aspects	Clean Float	Dirty Float
Definition	Clean float refers to a system where the exchange rate is purely determined by market forces without any intervention or interference from the central bank or government	Dirty float refers to a system where the exchange rate is allowed to fluctuate but may be subject to occasional intervention or management by the central bank or government
Central Bank Intervention	No direct intervention or management by the central bank or government in the foreign exchange market	Central Bank may occasionally intervene in the foreign exchange market to stabilize or influence the exchange rate
Exchange Rate stability	Exchange rates are subject to market forces, leading to potentially higher volatility and fluctuations	Exchange rates may be influenced or stabilized by occasional central bank intervention, resulting in relatively more stable exchange rate
Market Forces	Market forces of supply and demand primarily determine the exchange rate	Market forces still play a role in determining the exchange rate, but occasional central bank interventions may influence it
Flexibility	Exchange rate movements are flexible and respond solely to market dynamics	Exchange rates may be subject to occasional adjustments or management by the central bank or government for policy reasons
Transparency	The exchange rate determination is transparent and based on market mechanisms	The exchange rate determination may be less transparent as the central bank’s occasional interventions may not be disclosed
Exchange Rate Stability and Predictability	Exchange rate may experience higher volatility and wider fluctuations, making it harder to predict future rates	Exchange rates may experience relatively more stability and predictability due to occasional central bank interventions
Government Influence	The government does not directly influence or manage the exchange rate	The government or central bank may have some influence or control over the exchange rate through occasional interventions.