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

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For example: Suppose that bilateral central rate for FF and DM is set at 335.386FF=100DM (or 3.35 FF=1DM) as of 1995. This is a fixed parity with 2.25% margin of fluctuations on each side: The FF can go as low as 343.050FF=100DM or as high as 327.92FF=100DM).

If the actual FF/DM bilateral rate hits or exceeds 343.050FF=100DM, then FF is about to cross the bilateral margin on the low edge (weak FF and strong DM), then Banque de France is required to buy its own currency against the DM on the Paris foreign exchange market and the Bundesbank is required to lend DMs to Banque de France so that the latter can purchase FF using the DMs at its disposal. Since Banque de France has to repay its intervention credit in DMs or ECUs, its reserves at the EMCF is immediately reduced or its liability is recorded while Bundesbank’s reserves at the EMCF are immediately increased.

In support of this intervention, Bundesbank is required to sell its currency against the FF on the Frankfurt exchange market. As a result of these transactions, the monetary base and foreign exchange reserves in Germany increase and the monetary base and foreign exchange reserves of France decreases.

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