Exchange Rate Mechanism (ERM) systems are used to control the exchange rate of a currency relative to the other currency. In the extreme level, ERMs allow you to trade currency, without currency intervention from the central banks or governments.
There are two categories of ERMS, the floating and fixed ERMs.
How does it Work?
The actively managed ERMs work by setting a reasonable trading range for the exchange rates of a particular currency. Then, it enforces the range through interventions.
For instance, Japan set a lower and upper bound for the Japanese yen relative to the U.S. dollar. That way, the central bank of Japan can intervene in the currency once the Japanese Yen appreciates above the level they set before. Consequently, the Japanese government can sell the Japanese yen with a lower market in the market.
Other than that, there are also other tools to defend exchange rates. The example of those tools is domestic interest rates, tariffs, and quotas, or switching to a floating ERMs.
As the example, rising interest rates can be a strong tool to increase the valuation of a certain currency. Yet, central banks may encounter difficulties to do it if the economy is performing well.
Also Read: Defining Currency Intervention
The ERMs Practice
The most well-known example of an ERM practice is the European Exchange Rate Mechanism. This exchange rate mechanism is to reduce the variability of the exchange rates. The central bank also uses it to get monetary stability across Europe when they first introduced Euro on January 1, 1999.
The Europe central bank used ERM to normalize the exchange rates between European member’s currency before they integrated the currencies.
Other than Europe, China can also be one of the successful examples of ERM usage. It maintains a flexible ERM toward the U.S. dollars.
