Econ 355: European Exchange Rate Mechanism (erm) The European exchange rate mechanism

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ECON 355: European Exchange Rate Mechanism (ERM)

The European exchange rate mechanism (or ERM) was a system introduced by the European Community in March 1979, as part of the European Monetary System (EMS), to reduce exchange-rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of a single currency, the Euro, which took place in January 1999. All 9 member states of the Community at the time joined the EMS.1

Until 1999, all member states that participated in the ERM, also participated in the ECU.

European Currency Unit

The European Currency Unit (₠; ECU) was a basket of the currencies of the European Community member states, used as the unit of account of the European Community, before being replaced by the Euro. The European Exchange Rate Mechanism attempted to minimize fluctuations between member state currencies and the ECU. The ECU was also used in some international financial transactions. Just as the dollar was at the center of the BW system and was its de facto numeraire and reserve asset (dollar is “as good as gold”), the ECU was designed to be the unit of account and the reserve asset at the center of the European Monetary System (EMS).2

The ERM is based on the concept of fixed currency exchange rate margins, but with exchange rates variable with those margins. It was a new institutional framework for maintaining stability between Community currencies while allowing them to float against the other currencies.

Before the introduction of the Euro, exchange rates were based on the ECU, the European unit of account, whose value was determined as a weighted average of the participating currencies. It was just more than a unit of account as ECU was also an official reserve asset held by the European Monetary Cooperation Fund (later replaced with a European Monetary Fund).3

A grid of bilateral rates was calculated on the basis of these central rates expressed in ECUs, and currency fluctuations had to be contained within a margin of 2.25% either side of the bilateral rates (with the exception of the Italian lira, which was allowed a margin of 6%). For example: FF/ECU divided by DM/ECU is the FF/DM bilateral central rate as a ratio of two ECU central rates and the margin of fluctuation between FF and DM bilateral central rate could not exceed the + or – 2.25 percent.

The structure of the bilateral central rates was to be agreed unanimously by the Ecofin Council, composed of the Finance Ministers and by the Governors of the Central Banks of the participating countries. The bilateral central rates were aligned 11 times between 1979 and 1987, once in 1990 and 5 times between 1992 and 1993 (due to the speculative attack on the weaker currencies of the ERM). Last realignment was in 1995.

ECU also provided an early warning signal to participating member States that their macroeconomic policies are inconsistent with the established ECU parities (central parities).

ERM assigned more evenly the obligations between Member States with strong and weak currencies: They both had a legal obligation to intervene in unlimited amounts to defend these margins. The country with the strong currency had the obligation to prevent further appreciation and the country with the weak currency had the obligation to prevent further depreciation in excess of the predetermined margin of 2.25% either side of the bilateral rates. Determined intervention and loan arrangements protected the participating currencies from greater exchange rates fluctuations.

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