Exchange Rate Mechanism

Updated on January 29, 2024
Article byPriya Choubey
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Exchange Rate Mechanism (ERM)?

The exchange rate mechanism (ERM) is a framework adopted by the central banks of different nations to control their exchange rates concerning the currencies of other countries. It aims to stabilize and strengthen a country’s currency in the foreign exchange market for international trade, investment, and exchange.

Exchange Rate Mechanism

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ERM is an economic practice followed by central banks or governments for modifying monetary policies to stabilize the exchange rates. This commitment helps to minimize the risks associated with currency fluctuations by either fixing their exchange rate to a specific value or allowing only a narrow range of changes. A robust exchange rate regime helps the economy to attract foreign investors and firms.

Key Takeaways

  • An exchange rate mechanism is a system that enables the central banks and the government of various countries to manage and regulate the exchange rates of their currencies in the foreign exchange market.
  • The primary objective of ERM is to attain economic stability and improve the predictability of the exchange rates in the forex market to shield the traders, investors, and firms engaged in an exchange of foreign currencies.
  • The different ERMs adopted by the nations include fixed exchange rates, floating exchange rates, managed float, crawling pegs, currency boards, and dollarization.

Exchange Rate Mechanism (ERM) Explained

Exchange rate mechanisms help promote stability, facilitate trade, and enable effective economic management. It allows the central bank and government to use monetary policies to strengthen the nation’s currency’s position in the foreign exchange market. To begin with, let us understand the functionality of foreign exchange.

The foreign exchange rate mechanism refers to the system implemented by central banks and governments to control and stabilize the exchange rates of currencies in the international market. It is crucial for international trade, as it involves paying for goods or services in the seller’s currency. Thus, to trade in the global marketplace, foreign exchange is crucial. Such an arrangement encounters huge trading volumes every day except Saturday and Sunday. They allow for the exchange of different currencies but at a lower margin than equity and other commodities.

The choice of ERM aligns with a country’s specific economic circumstances and policy objectives. The primary objectives of the ERM are to bring economic stability and provide predictability of exchange rates for securing international trade and investment activities. Its purpose is to maintain sufficient international reserves to shield the economy from external shocks. It, thus, checks excessive volatility in currency exchange rates and enhances overall economic performance.

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Types

The models of exchange rate mechanisms are crucial in shaping the foreign exchange market. The countries sometimes adopt a combination of different mechanisms or adjust the existing system based on their economic circumstances.

Let us now go through the prominent types of exchange rate regimes:

  1. Fixed Exchange Rate Mechanism: In a fixed exchange rate system, a country’s currency is linked to a specific reference currency, such as the U.S. dollar or a group of currencies. The exchange rate doesn’t change much and usually stays within 1%. The government or central banks has no control over such exchange rate fluctuations.
  2. Floating Exchange Rate: The value of the currency is determined by market forces of supply and demand. It fluctuates freely based on factors like interest rates, inflation, and market conditions. The government or central bank doesn’t control these fluctuations.
  3. Managed Floating Exchange Rate: The currency’s value is influenced by market forces, but the central bank intervenes to stabilize it during significant fluctuations. They use foreign exchange reserves to keep the currency within the desired range. It helps protect importers and exporters from extreme volatility.
  4. Crawling Peg: The exchange rate is adjusted periodically within a specific range. It’s usually based on money supply, inflation, and trade imbalances. The central bank changes the rate at fixed intervals to manage economic conditions.
  5. Currency Board: The country’s currency is fully backed by a foreign reserve currency, such as the U.S. dollar or the euro. This mechanism eliminates the central bank’s ability to manage the exchange rate and money supply independently.
  6. Dollarization: The country adopts a foreign currency, often the U.S. dollar, as its official currency. It means the country stops using its currency and relies entirely on foreign currency. The monetary policy of the foreign country becomes the de facto policy for the dollarized country.

Examples

ERM can have a significant impact on currency exchange dynamics and international trade. Exploring a few examples can help illustrate their importance and functioning.

Example #1

Suppose Country A and Country B implement the “Stable Currency Pact” (SCP) ERM. Under the SCP, both countries commit to maintaining a fixed exchange rate between their currencies. The central banks of Country A and Country B closely monitor and intervene in the foreign exchange market whenever necessary to keep the exchange rate stable. This ERM promotes stability in trade and investment between the two countries, fostering economic cooperation and growth.

Example #2

ERMs have been implemented in various forms across different regions and periods. One notable example is the European ERM, which was in place from 1979 until it transformed into the European Monetary System (EMS) in 1999, ultimately leading to the establishment of the euro. The ERM was crucial in European currencies’ convergence and the eurozone‘s formation.

Example #3

The most popular ERM is the managed float. The Japanese currency Yen, experienced significant fluctuations in the foreign exchange market after the nation adopted the floating exchange rate mechanism in 1973. The exchange rates were stabilized through the involvement of the Bank of Japan, which exercised control over the purchasing and selling of foreign currency as necessary to maintain stability. Many other countries, including the USA, India, China, and Georgia, have a managed floating exchange rate system.

Advantages

ERMs are crucial for nations engaged in cross-border trade and investing for the following reasons:

  • Economic Stability: ERMs provide price stability by managing exchange rates. Central banks can influence import and export prices to control inflationary pressures, thus reducing market volatility.
  • Predictability: A robust regime helps businesses, investors, and individuals engaged in international trade and investment to predict exchange rate fluctuations and act accordingly. 
  • Promotes International Trade: It enables international trade practices and enhances a country’s competitiveness by making its exports more affordable and attractive in global markets. It can also incentivize domestic consumers to buy locally-produced goods instead of relying heavily on imports.
  • Prevents Speculation: The fixed and managed floating systems can deter a country’s currency speculation. Hence by affixing a specific exchange rate, central banks demonstrate their willingness to defend the currency’s value, which can discourage speculative investors from manipulating the exchange rate for short-term gains.
  • Economic Adjustment: The floating exchange rate regime helps to rectify trade imbalances since the currency value adjusts automatically based on market forces. In the fixed exchange rate systems, central banks actively intervene to address trade imbalances or change the pegged rate periodically. Thus, it aids in the balance of payment corrections.
  • International Cooperation: ERMs can foster international cooperation among countries by providing common currency arrangements or coordinating exchange rate policies to promote economic integration and facilitate cross-border trade and investment.
  • Monetary Policy Autonomy: In a floating exchange rate regime, the central banks can adjust interest rates and implement other monetary policy tools to control inflation and stabilize the economy.

Frequently Asked Questions (FAQs)

1. What is the exchange rate mechanism of 1999?

The ERM II was introduced on January 1, 1999, to offset the shortcomings of the previous exchange rate mechanism. It aimed to stabilize the exchange rate fluctuations relative to the euro’s exchange with the other European currencies. Also, it paved the way for exchanging non-euro currencies with European currencies.

2. Who sets exchange rates?

A combination of factors determines exchange rates. These include the monetary policy measures implemented by a country’s monetary authority and the dynamics of the foreign exchange market, which are influenced by the demand and supply of currencies.

3. What factors affect the exchange rate mechanism?

The factors that lead to exchange rate fluctuations are currency supply and demand, inflation, government intervention, balance of payment, interest rate, government debt, etc.

4. Why are exchange rates important?

The exchange rates facilitate the international trade and investment between the countries. It impacts a nation’s economic performance on the global platform and affects the balance of payment.

This has been a guide to What Is Exchange Rate Mechanism. We explain the concept along with its types, examples, & advantages. You can learn more about it from the following articles –

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