Understanding the Exchange Rate Mechanism

Monetary policy is the procedure of formulating, announcing, and implementing the program of action taken by the bank's central office, the board of currency, or other authorities in a nation's monetary system, which regulates the amount of money that is in the economy, as well as the channels by that new money, is distributed. In the case of a currency board, the control of exchange rates and the supply of money is entrusted to a monetary body that decides on the value of the nation's currency. In most cases, the financial authority is given the authority to secure each currency unit in circulation by foreign currency.

A mechanism for exchange is not new. In the past, all new currencies were initially an exchange mechanism fixed that tracked gold or other widely traded commodities. It is loosely dependent on margins of exchange fixed, which means that prices fluctuate in certain ranges. A lower and upper bound interval permits the currency to experience some fluctuations without creating additional economic risk. The idea behind the mechanism of exchange rates for currency is often referred to as a semi-pegged currency.

Working

ERM permits central banks to influence the exchange rates for currency on international exchange markets. Furthermore, ERM enables the central bank to alter the currency peg to exert an impact on exports and imports and draw foreign direct investment and foreign portfolio investments. The mechanism for exchange rates is essential to keep the exchange rate stable and limit fluctuations in the currency market. Reducing fluctuations in foreign currencies is crucial since it helps the market be more reliable to external investors.

Exchange rates are controlled by mechanisms designed to create a reasonable trading rate for a currency's exchange rate. The range comprises lower and upper bounds. The nation must implement the range by means of interventions, typically through the sale or purchase of currency. Take the following example. Country A wants to hold its currency at a higher value in value than the currency of Country B. To keep the desired rate of exchange, the central bank must sell foreign currency out of its reserves and then buy the currency of its domestic counterpart.

Types of Exchange Rate Mechanisms

Fixed Exchange Rate

Fixed exchange rates are an exchange rate that is based on the value of a currency set in relation to a different currency, a basket of currencies, or gold. There are many advantages and drawbacks to the fixed exchange rate. One of the major advantages is that a fixed exchange rate will not change in response to market conditions. This helps to improve investment and trade in the international market. Fixed exchange rates can be utilized to regulate currency behavior by keeping inflation to a minimum.

Adjustable Peg Rate

A variable peg rate can float in the market and change according to economic conditions. The central bank will generally establish a certain amount of flexibility anchored to an agreed-upon threshold or peg. It is the central bank's duty to make sure that the targeted exchange rate is maintained within the peg. This rate of exchange is commonly utilized by the Chinese, who are the ones who peg the Chinese yuan against the dollar U.S. dollar. China utilizes its peg rate to make its products more appealing to buyers in the international market than other countries that supply similar goods.

Exchange Rate Mechanism Example

Let's say Country X wants to stabilize its currency compared to the currency of Z. A mechanism for exchange rates is set up to keep the exchange rate of Country X within a range that includes a lower and upper bound rate. Suppose the rate at which Country X's currency is exchanged is higher than the upper bound. In that case, the country sells its currency out of its reserves and purchases the currency of Country Z to ensure that the currency stays within the bounds. If, on the other hand, the exchange rate of Country X falls below its lower bound, the central bank will purchase its currency and sell Country Z's currency from its reserves. In general central banks of both countries work together to ensure the stability of an exchange rate structure.

ERMs in Practice

It was created to decrease fluctuations in exchange rates and attain financial stability throughout Europe before the introduction of the euro in the year 1999. The ERM could allow for the normalization of exchange rates of the nations before they were integrated to prevent issues with the market from finding their roots. Even though the initial European ERM was ended and replaced by its successor, the European ERM II was later implemented to assist those new to the eurozone more easily integrate.