ELO, or the Electric Light Orchestra, is an English rock band formed in… oops – wrong 70s acronym! ERM, or the European Exchange Rate Mechanism, is the subject of today’s discussion. Like ELO, ERM was founded in the 70s, but that’s where the similarities end.

The Exchange Rate Mechanism – A Background

An exchange rate is the value of one currency in relation to another. As of 22/10/18, 1 British pound sterling will get you 1.30 dollars, for example. Exchange rate mechanisms work by placing margin limits on a currency’s exchange rate. It can be seen as a halfway measure between a floating exchange rate (where market demand for a currency dictates its exchange rate) and a fixed exchange rate (where the government controls the value of a country’s currency in relation to another). Businesses are often concerned with exchange rates if they import or export goods, as this can have a significant impact on their profits and production costs, for example.

Exchange Rates

OK, so why would a country want to manipulate its exchange rate? A country that exports a lot of goods to a particular country may see the price of their currency increase in relation to the importer currency – here’s our demand factor; the exporter is seeing significant demand for their products, and they want to be paid in their home currency. Sounds like great news, but it’s not quite so simple; if the exchange rate increases too much, the importers will begin looking elsewhere for cheaper alternatives. The demand for products (and currency) would then decrease, and the exchange rate would fall. In this case, the export demand might be seen as vital for a country’s economy, which would lead a sensible government to control their exchange rate in relation to their main importer to avoid a boom and bust scenario (where an economy has extreme periods of expansion and contraction, and little stability). 

Governments can also affect the exchange rate by manipulating interest rates (the percentage you receive back for lending). By raising interest rates, a government is encouraging outside investment (as investors get more back for the amount they invest), which increases demand for a currency. Likewise, they could decrease interest rates, which would result in lower investment in a currency; this would likely see investors look for currencies with more attractive exchange rates.  

Europe 

More 70s music references! Anyway, time for another acronym – ECU – the European Currency Unit – described a central exchange rate for all European currencies. The ECU was a way to give European currencies a means of creating rates against other countries as well as a central exchange rate for each currency within Europe; in essence, the ECU was the first unit of European currency. Along with ERM, ECU was created as a precursor to the Euro; both aimed to control European currencies in relation to one another to develop overall stability. As part of the move to create the single currency, “membership of the ERM has become a Brussels-imposed condition,” wrote the BBC in 1992. 

These details provide the foundation for understanding one of the UK’s most significant financial crises – Black Wednesday – the day the UK dramatically left the ERM. Join us next time to see how Black Wednesday unfolded.

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