Monetary System: Exchange Rate Mechanism and Arrangements

Exchange rate mechanisms, or ERMs, are systems designed to control a currency’s exchange rate relative to other currencies.

At their extremes, floating ERMs allow currencies to trade without intervention by governments and central banks, while fixed ERMs involve any measures necessary to keep rates set at a particular value. Managed ERMs fall somewhere between these two categories, with the European Exchange Rate Mechanism (“ERM II”) being the most popular example that’s still being used today for countries looking to join Europe’s monetary union.

History of ERMs

Most currencies historically began on a fixed exchange rate mechanisms, with their prices set to commodities like gold. In fact, the U.S. dollar was officially fixed to goldprices until October of 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, including the U.S.’s largest trading partner — China — who maintains some level of control to this day.

By the 1990s, many countries adopted floating ERMs that have remained the most popular option in order to maintain liquidity and reduce economic risks. Exceptions to the rule include countries like Venezuela and Argentina, as well as countries that have experienced temporary rises in their currency valuations. For example, Japan and Switzerland both adopted semi-fixed ERMs in response to the European Financial Crisis that led to a sharp increase in their value.

Fixed ERM helped reduce the uncertainty associated with fluctuations and 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 maintaining fixed ERMs.

How ERMs Work

Actively managed exchange rate mechanisms work by setting a reasonable trading range for a currency’s exchange rate and then enforcing the range via interventions. For example, Japan may set an upper and lower bound on the Japanese yen relative to the U.S. dollar. If the Japanese yen appreciates above this level, the Bank of Japan can intervene by buying large quantities of U.S. dollars and selling Japanese 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 strategies have mixed effects and reliability depending on the situation. For example, raising interest rates can be an effective way to increase a currency’s valuation, but it’s difficult to do if the economy is performing well.

Since central banks can print their own domestic currencies in theoretically unlimited quantities, 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, including George Soro’s famous run on the Bank of England. In these instances, traders might utilize leverage to make enormous bets against a currency that make interventions too expensive for central banks to undertake without causing significant inflation.

ERMs in Practice

The most popular example of an exchange rate mechanism is the European Exchange Rate Mechanism, which was designed to reduce exchange rate variability and achieve monetary stability in Europe prior to the introduction of the euro on January 1, 1999. The ERM was designed to normalize the currency exchange rates between these countries before they were integrated in order to avoid any significant problems with the market finding its bearings.

While the original European ERM has been dissolved, the European ERM II was adopted on May 1, 2004, in order to help new members of the eurozone better integrate. Countries involved include Estonia, Lithuania, Slovenia, Cypriot, Latvia, and Slovakia among others. Sweden has been allowed to stay out of the ERM, while Switzerland has always floated completely independently until the Eurozone Debt Crisis led to a minimum 1.20 peg to the euro.

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