Economic float

What Is Economic Float?

Economic float refers to the amount of money within the banking system that is temporarily counted twice due to delays in the processing of financial transactions. This phenomenon primarily arises from the time lag between when a payment is initiated by one party and when the corresponding funds are actually deducted from their account, while simultaneously being credited to the recipient's account. It is a concept central to monetary policy and banking systems, impacting the accurate measurement of the money supply.

Economic float effectively means that for a brief period, the same sum of money appears as an asset on the books of both the payer's and the payee's banks. While typically associated with paper checks, where mailing and clearing times create these discrepancies, similar delays can occur in other payment methods, albeit often for shorter durations. Understanding economic float is crucial for financial institutions and central banks, as it influences overall liquidity in the economy.

History and Origin

The concept of economic float gained significant prominence with the widespread use of checks as a primary payment method. Historically, the physical movement and processing of paper checks introduced inherent delays in the settlement of funds. For instance, when a check was written, the funds might still be in the payer's account even after the payee deposited the check and received provisional credit. This temporary duplication of funds constituted float.

In the United States, Federal Reserve float, specifically, refers to the float created within the Federal Reserve's check collection system²⁸. During the late 1970s, Federal Reserve check float rose to historically high levels, presenting challenges for the central bank in predicting bank reserves for its monetary policy operations²⁷. Measures to reduce this float, including improved transportation and processing technologies, were implemented in the early 1980s²⁶. The Monetary Control Act of 1980 further directed the Federal Reserve to price its float, essentially charging banks for the interest-free reserves provided by the float, which further incentivized its reduction²⁵.

Key Takeaways

• Economic float represents money simultaneously recorded in both the payer's and payee's accounts due to transaction processing delays.
• It primarily results from the time required for checks to clear between banks.
• Float can temporarily inflate the measured money supply and impact bank reserves.
• Technological advancements, particularly electronic payments, have significantly reduced the prevalence and magnitude of economic float.
• While typically benign, exploiting economic float through illicit means, such as check kiting, is illegal.

Formula and Calculation

Economic float, especially from a corporate or banking perspective, can be quantified to understand its impact on cash flow. A common measure is the average daily float. This calculation helps businesses assess the value of funds tied up or temporarily available due to clearing delays.

The general formula for measuring float from a firm's perspective is:

[
\text{Float} = \text{Firm's Available Bank Balance} - \text{Firm's Book Balance}
]

Where:

• Firm's Available Bank Balance is the amount of cash a firm actually has access to in its bank account.
• Firm's Book Balance is the amount of cash reflected in the firm's own accounting records.

For calculating the average daily float over a period, particularly for checks in the collection process:

[
\text{Average Daily Float} = \frac{\sum (\text{Amount of Float} \times \text{Number of Days Outstanding})}{\text{Total Number of Days in Period}}
]

This formula helps assess the typical volume of funds affected by payment processing delays,²⁴.

Interpreting the Economic Float

Interpreting economic float largely depends on the perspective: that of an individual, a business, or a central bank. For individuals and businesses, understanding float can influence decisions related to payment timing and cash management. A positive float for a payee means they have received credit before the payer's account is debited, giving them earlier access to funds. Conversely, a positive float for a payer means they have sent a payment, but the funds have not yet left their account, allowing them to retain the use of those funds for a longer period. This timing can provide an opportunity to earn interest on funds before they clear or to ensure sufficient balances for upcoming obligations²³.

For a central bank, understanding the aggregate economic float is crucial for effective monetary policy implementation. Large and unpredictable fluctuations in float can complicate efforts to manage bank reserves and target specific interest rates in the financial system²². Therefore, central banks often monitor and forecast float levels to accurately gauge the actual amount of reserves in the system and adjust their operations accordingly²¹.

Hypothetical Example

Consider "Alpha Co." which regularly writes checks to its suppliers. On Monday, Alpha Co. issues a check for $50,000 to "Beta Inc." for raw materials. Alpha Co.'s internal accounting records immediately reduce its cash balance by $50,000. However, Beta Inc. does not deposit the check until Tuesday, and its bank takes two business days to clear the check.

From Monday morning until the end of Wednesday, the $50,000 "exists" in two places: Alpha Co.'s bank account still shows the $50,000 (because the check hasn't yet been presented for payment), and Beta Inc.'s bank account provisionally shows a $50,000 credit. This overlapping period is the economic float. Alpha Co. benefits from this disbursement float by having the use of the $50,000 for an additional three days. Beta Inc. experiences collection float during this period until the funds are fully available for withdrawal.

If Alpha Co. then calculates its average daily float for this single transaction over a five-day week (Monday to Friday), assuming the float was $50,000 for 3 days:

This indicates that, on average, $30,000 of funds related to this transaction were in float each day over that period.

Practical Applications

Economic float has several practical applications across various levels of finance:

• Corporate Cash Management: Businesses actively manage float to optimize their cash flow. By timing disbursements (e.g., mailing checks shortly before the due date) and accelerating collections (e.g., using lockbox systems for incoming checks), companies aim to maximize the funds available in their bank accounts for as long as possible²⁰. This allows them to keep money invested, potentially earning returns, or to maintain a stronger cash position for operational needs¹⁹.
• Central Bank Operations: Federal Reserve float, specifically, impacts the level of bank reserves within the system. The Federal Reserve monitors float closely because unexpected changes can influence the aggregate level of reserves, making it more challenging to achieve its targets for the federal funds rate and conduct effective open market operations. The ability to accurately predict and manage float is essential for maintaining stability in the monetary system.
• Payment System Design: Understanding float helps in designing more efficient payment systems. The push towards electronic payments, such as wire transfers and automated clearing house (ACH) transactions, aims to minimize float by reducing the time lag between payment initiation and final settlement¹⁸. This increases payment certainty and efficiency within the broader financial market infrastructure.

For instance, the Federal Reserve Bank of San Francisco has detailed how "Federal Reserve float represents an interest-free loan from the Fed to the banking system and can complicate monetary policy if unpredictable".

Limitations and Criticisms

While economic float has historically been a significant aspect of banking and finance, its relevance has diminished over time. One primary criticism is that float, particularly that caused by paper checks, represents an inefficiency in the payments system¹⁷. The delays inherent in check processing mean that funds are not immediately available, which can be an opportunity cost for the payee if they could otherwise invest those funds¹⁶.

Moreover, the temporary duplication of funds due to float can, in some instances, be exploited for illicit activities. Schemes like check kiting involve deliberately manipulating float by writing checks on accounts with insufficient funds, relying on the processing delay to deposit funds from another account before the first check clears¹⁵. Such actions are illegal and can lead to severe penalties, falling under categories like wire fraud or mail fraud if interstate or postal services are involved¹⁴. The E.F. Hutton wire fraud case in 1985 is a notable historical example where a major firm misused float¹³.

Perhaps the most significant limitation of economic float in the modern era is its rapid reduction due to technological advancements. The widespread adoption of electronic fund transfers, direct deposit, electronic check processing (e.g., check imaging), and real-time payment systems has dramatically compressed the time windows during which float can occur¹²,¹¹. As more transactions become instantaneous, the temporary "double-counting" of money becomes less prevalent, lessening the impact of economic float on the reserve requirements of banks and the overall gross domestic product¹⁰. This technological shift essentially renders a concept once critical for financial operations less impactful⁹.

Economic Float vs. Currency Float

Economic float and currency float are distinct concepts within finance, though both use the term "float." The confusion arises from the common English word but their application in different financial contexts.

Economic Float (also known as banking float or payment system float) refers to the temporary duplication of money within the banking system due to delays in clearing and settlement processes. It is typically associated with paper-based transactions like checks, where the funds are credited to the payee's account before being debited from the payer's account. This phenomenon directly affects a bank's balance sheet and the calculation of overall money supply.

Currency Float (or floating exchange rate) describes an exchange rate regime where a country's currency value is determined by market forces of supply and demand in the foreign exchange market, rather than being fixed or pegged by a government or central bank⁸. In a floating exchange rate system, the value of the currency is allowed to fluctuate freely, adjusting to economic conditions and international trade flows⁷,⁶. This provides a country with greater autonomy over its monetary policy.

The key distinction lies in what is "floating": economic float refers to the temporary existence of money in two places due to processing delays within a domestic payment system, while currency float refers to the market-determined movement of a nation's currency value relative to others in the global capital markets.

FAQs

1. What is the main cause of economic float?

The primary cause of economic float is the time delay inherent in processing financial transactions, particularly paper checks. When a check is written, sent, deposited, and then routed back to the payer's bank for debiting, a period exists where the funds are effectively counted in both accounts⁵.

2. Is economic float still relevant today?

While still present, the relevance and magnitude of economic float have significantly decreased due to the widespread adoption of electronic payments, direct deposits, and real-time payment systems. These technologies have dramatically reduced the time delays that historically created float⁴.

3. How does economic float affect banks?

Economic float affects banks by temporarily influencing their reserves at the central bank. If a bank credits a customer's account for a deposited check before the funds are collected from the paying bank, it effectively extends an interest-free loan until the check clears. Central banks monitor aggregate float as it impacts the overall money supply and their ability to manage interest rates³.

4. Can individuals benefit from economic float?

Yes, individuals can benefit from economic float by strategically timing their payments and deposits. For example, writing a check for a bill a few days before having the full amount in the bank, knowing the check will take time to clear, is a way to utilize float. However, this carries risks if the funds are not available by the time the check is presented, potentially leading to overdrafts or other issues like overdraft protection charges². Misusing float with the intent to defraud, such as through check kiting, is illegal¹.