What Is an Exchange Rate Mechanism (ERM)?
Let me explain what an exchange rate mechanism, or ERM, really is. It's a set of procedures that countries use to manage their currency's exchange rate compared to others. This is a key part of any economy's monetary policy, and central banks are the ones who put it into action.
You'll see this mechanism in play if a country has a fixed exchange rate tied to a currency peg, or something like a constrained floating rate—think adjustable peg or crawling peg.
Key Takeaways
- An exchange rate mechanism (ERM) is a way that governments can influence the relative price of their national currency in forex markets.
- The ERM allows the central bank to tweak a currency peg in order to normalize trade and/or the influence of inflation.
- More broadly, ERM is used to keep exchange rates stable and minimize currency rate volatility in the market.
Understanding the Exchange Rate Mechanism
You should know that monetary policy involves drafting, announcing, and implementing actions by the central bank, currency board, or other authority to control the money supply and how new money enters the economy. With a currency board, the exchange rate and money supply are managed by an authority that decides the nation's currency value, often backing domestic currency with foreign reserves.
ERM isn't a new idea. Most new currencies historically started with a fixed exchange mechanism tracking gold or a commodity. It's based on fixed exchange rate margins where rates fluctuate within set bounds.
This setup with upper and lower bounds lets the currency vary a bit without losing liquidity or adding economic risks. We also call this a semi-pegged currency system.
Real World Example: The European Exchange Rate Mechanism
The most prominent ERM example happened in Europe in the late 1970s. The European Economic Community launched the ERM in 1979 as part of the European Monetary System (EMS) to cut down on exchange rate swings and build stability before shifting to a single currency. It was meant to even out rates between countries to prevent price discovery issues during integration.
Remember, on September 16, 1992—known as Black Wednesday—the pound sterling crashed, forcing Britain to pull out of the European ERM.
Britain joined to keep the pound and other currencies from deviating more than 6%. But things boiled over in 1992, leading to withdrawal.
Real World Example: Soros and Black Wednesday
In the lead-up to 1992, investor George Soros built a huge short position on the pound, betting it would drop below the ERM's lower band. He saw that Britain entered under bad terms—the rate was too high, and the economy was weak. On Black Wednesday in September 1992, Soros sold off his position, overwhelming the Bank of England's efforts to prop up the pound.
By the end of the decade, the European ERM dissolved, but ERM II took its place in January 1999. This new mechanism keeps exchange rates between the euro and other EU currencies from disrupting the single market's stability. It also aids non-euro countries in preparing for euro adoption.
Most non-euro countries commit to a 15% fluctuation range against a central rate. The European Central Bank and others can step in if needed to stay within that window. Countries like Greece, Denmark, and Lithuania have been or are part of ERM II.
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