Dirty Floating

Published Apr 7, 2024

Definition of Dirty Floating

Dirty floating, also referred to as managed floating, is a monetary policy regime wherein a country’s currency exchange rate is nominally allowed to float freely according to the foreign exchange market mechanisms of supply and demand. However, in practice, the government or central bank may intervene to stabilize or steer the currency towards desired levels. This contrasts with a pure floating currency, where the price is determined entirely by the free market, or a fixed (pegged) currency rate, which is set and maintained by a government.

Example

Consider the country of Economica, which has adopted a dirty floating exchange rate system for its currency, the Economico. Economica’s central bank closely monitors the exchange rate of the Economico against the dollar. Whenever the Economico threatens to fall too sharply in value—potentially harming the nation’s exporters by making their goods more expensive abroad—the central bank might enter the foreign exchange market to buy Economicos, thus increasing the demand for the currency and supporting its value. Conversely, if the Economico gets too strong, potentially making imports prohibitively expensive and hurting domestic consumers, the central bank might sell Economicos to depress its value.

Why Dirty Floating Matters

Dirty floating systems offer countries a balance between having control over their currency and allowing some level of market determination of exchange rates. This flexibility can be crucial during economic turbulence, providing tools to combat excessive volatility. For example, by devaluing their currency, countries can make their exports cheaper and more competitive internationally, potentially boosting economic growth. On the other hand, preventing excessive appreciation of the currency can help keep inflation in check by making imports less expensive.

However, such interventions are not without criticism. Frequent interventions under a dirty float system can lead to international tensions and might distort trade balances. Moreover, managing the exchange rate may distract central banks from other crucial goals like controlling inflation or unemployment.

Frequently Asked Questions (FAQ)

How does dirty floating affect international trade?

Dirty floating can affect international trade by influencing the competitiveness of a country’s exports and the cost of imports. By managing their currency’s value, countries can potentially gain an advantage in international markets or protect their domestic industries from foreign competition. However, if used aggressively, this practice might lead to retaliatory policies or trade disputes from trading partners.

What are the main tools used in dirty floating?

The primary tools used in a dirty floating system include buying and selling the nation’s currency in the foreign exchange markets (forex interventions), altering interest rates to influence the demand for the currency, and implementing capital controls to restrict the flow of foreign capital in and out of the country. These measures aim to influence the exchange rate without resorting to a fixed peg.

What are the risks of dirty floating?

The risks associated with dirty floating include potential conflicts with other monetary policy goals, like controlling inflation, and the possibility of causing or exacerbating geopolitical tensions through perceived currency manipulation. Additionally, significant intervention in foreign exchange markets can lead to large costs for a country’s central bank, possibly affecting its balance sheet negatively if currency values move against expectations.

Can dirty floating be considered a form of currency manipulation?

Dirty floating can be viewed as a form of currency manipulation, especially if a country uses it with the intent to gain unfair competitive advantages in international trade. International bodies like the International Monetary Fund (IMF) monitor exchange rate policies closely to assess whether countries are engaging in manipulative practices. However, distinguishing between legitimate market stabilization efforts and manipulative practices can be complex, often depending on the context and intent behind the interventions.