What is an Exchange Rate Mechanism (ERM)?
An exchange rate mechanism (ERM) is a device used by countries to manage the strength of their currency. The ERM is a critical pillar in any economy’s monetary policy and is frequently utilized by the central banks.
It is important to place strong controls over domestic currency to stimulate international trade through the management of domestic currency with respect to international currencies, which are traded on the foreign exchange market.
- Countries manage their country’s currency strength through a device called an exchange rate mechanism (ERM).
- The exchange rate mechanism allows central banks to influence domestic currency prices of currency in foreign exchange markets.
- Exchange rates that are actively managed through an adjustable peg rate establish a reasonable trading range for a currency’s exchange rate.
How Do Exchange Rate Mechanisms Work?
Originally, currencies began as a fixed exchange rate mechanism that tracked gold or other commodities. The exchange rate mechanism allows central banks to influence domestic currency prices of currency in foreign exchange markets.
Moreover, ERM enables the central bank to adjust the currency peg to exert a material impact on imports and exports, as well as attract foreign direct investment and foreign portfolio investment.
The exchange rate mechanism is critical to keeping exchange rates stable and controlling currency rate volatility in the market. Reducing foreign currency fluctuation is important, as it allows the market to become more predictable to outside investors.
Exchange rates that are actively managed through mechanisms set out to establish a reasonable trading range for a currency’s exchange rate. The range includes a lower bound and an upper bound. The country must enforce the range through interventions, usually through the purchase or sale of currency.
Consider the following example. Country A wishes to keep its currency greater than the value of Country B’s currency. To maintain the desired exchange rate, the central bank will sell foreign currency from its reserves and buy back domestic currency.
What are Different Types of Exchange Rate Mechanisms?
1. Fixed Exchange Rate
A fixed exchange rate is a type of exchange rate regime where a currency is fixed against the value of another currency, basket of other currencies, or gold.
There are several benefits and drawbacks of a fixed exchange rate. One major benefit is that a typical fixed exchange rate does not change based on market conditions. This allows for improved international trade and investments. The fixed exchange rate system can be used to control the behavior of currency by limiting inflation.
2. Adjustable Peg Rate
An adjustable peg rate floats on the market and changes with respect to economic conditions. Generally, the central bank will set a degree of flexibility anchored against a specific level or peg. It is then the central bank’s responsibility to ensure that the target exchange rate remains at the peg.
The peg rate is most notably used by the Chinese, who peg the Chinese yuan to the U.S. dollar. China uses the peg rate to make its exports more attractive to international buyers relative to other countries supplying the same goods.
Example of a Real-Life Use Case of an Exchange Rate Mechanism
The European exchange rate mechanism is a system introduced by the European Economic Community. The system was created as a component of the European Monetary System to reduce the overall variability surrounding the exchange rate.
The European ERM helps the European Union to stabilize the euro. Moreover, it allows the EU to evaluate potential eurozone members in terms of economic philosophy.
What is the Foreign Exchange Market?
The foreign exchange market refers to a global marketplace where foreign currency is exchanged. The market determines the price of all currencies on the market and carries out buying and selling transactions of currencies at the spot price or a predetermined future price.
The market helps international trade and investments by allowing parties to convert foreign currency into a liquid and high-volume market. The foreign exchange market’s unique characteristics include:
- Huge trading volume
- Geographic dispersion
- Market is open 24 hours except on weekends
- Low profitability margin compared to other asset classes
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant resources below: