What Is an Exchange Rate Mechanism?

Definition & Examples of ERMs

Global exchange rates
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Exchange rate mechanisms, or ERMs, are systems designed to control a currency's exchange rate relative to other currencies. They are a key monetary strategy used by central banks.

At their extremes, floating ERMs allow currencies to trade without intervention by governments and central banks. On the other hand, fixed ERMs involve any measures needed to keep rates set at a certain value. Managed ERMs fall somewhere in between. The European Exchange Rate Mechanism (ERM II) is a strong example that's still in use today for countries joining Europe's monetary union.

What Are Exchange Rate Mechanisms?

With no intervention, the value of one country's currency will naturally change in relation to another's. Depending on many economic and socio-political factors, these fluctuations can be large or small. ERMs are any measures a country puts in place to try to control these changes.

Most currencies historically began on a fixed ERMs, with their prices set to commodities like gold. In fact, the U.S. dollar was officially fixed to gold prices until 1976, when the government removed references to gold from official statutes. Some other countries began to fix their currencies to the U.S. dollar itself to limit volatility. This includes the U.S.'s largest trading partner, China—which maintains some level of control to this day.

By the 1990s, many countries adopted flexible ERMs. These have remained the most popular option in order to maintain liquidity and reduce economic risks. Governments using flexible ERMs will usually intervene to some degree in order to keep exchange rates within certain ranges.

  • Acronym: ERM

Important

Fixed ERMs helped reduce the uncertainty that came with fluctuations; they also potentially limited inflationary pressures. But flexible ERMs may have helped improve growth rates and liberated monetary policy to focus on domestic economies. For these reasons, most modern governments use flexible ERMs rather than fixed ERMs.

How ERMs Work

Actively managed ERMs work by setting a reasonable trading range for a currency's exchange rate. Then, it is enforced via interventions. For instance, Japan may set an upper and lower bound on the Japanese yen relative to the U.S. dollar. If the yen appreciates above this level, the Bank of Japan can intervene. They might do this by buying large quantities of U.S. dollars and selling yen into the market to lower the price.

Other tools that can be used to defend exchange rates include tariffs and quotas, domestic interest rates, monetary and fiscal policy, or switching to a floating ERM. These methods have mixed effects and reliability; it depends on the situation. For instance, raising interest rates can be an effective way to increase a currency's valuation. But it's difficult to do this if the economy is performing well.

Central banks can print their own domestic currencies in theoretically unlimited quantities. So most traders respect the limits of fixed or semi-fixed ERMs. There are some famous cases of these fixed or semi-fixed ERMs failing, though; these include George Soros' famous run on the Bank of England. In these instances, traders might use leverage to make enormous bets against a currency that makes interventions too expensive for central banks to undertake without causing high levels of inflation.

ERMs in Practice

The most popular example of an ERM is the European Exchange Rate Mechanism. It was designed to reduce exchange rate variability and achieve monetary stability in Europe prior to the introduction of the euro in 1999. The ERM could normalize the exchange rates between these countries before they were integrated. This was done in order to avoid any problems with the market finding its bearings.

While the original European ERM has been dissolved, the European ERM II was later adopted. This was done in order to help new members of the eurozone better integrate. Countries involved include Estonia, Lithuania, Slovenia, Cyprus, Latvia, and Slovakia, among others. Not all countries in the EU have adopted the ERM II.

China also maintains a flexible ERM with the U.S. dollar. But the People's Bank of China has been unpredictable when defending it. For instance, the country decided to let its currency float to a large extent; this was part of a controversial bid to become one of the world's official reserve currencies, alongside the U.S. dollar and the euro. Bu, skeptics argued that the devaluation simply made its exports cheaper at a time when the government wanted to boost economic growth rates.

Key Takeaways

  • Exchange rate mechanisms (ERMs) are used by countries to control the value of their currency in relation to other currencies.
  • A country's ERM is an important aspect of its economic and monetary policy.
  • ERMs can range from fixed control to totally free-floating; more countries have moved closer to free-floating versions with some intervention.
  • The ERM II is the EU's system for transitioning countries to the euro. It is perhaps the best example of ERMs in action.