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What is an Exchange Rate Mechanism?

H. Bliss
By H. Bliss
Updated May 16, 2024
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Exchange rate mechanism is a means of determining and stabilizing exchange rates by restricting how much the value of currency can change. This type of system is sometimes called a semi-pegged system because it allows fluctuation of currency prices within a margin set by currency authorities. The exchange rate mechanism was created as one means of reducing unpredictable exchange rate variations in currency. One of the largest exchange rate mechanisms was the European Exchange Rate Mechanism (ERM), part of the European Monetary System (EMS), which was later replaced after the creation of the Euro, a European currency unit that was adopted in 1999.

The system that sets exchange rates values can be either pegged or free. A pegged exchange rate system has values that are set and controlled by the government. Pegged systems can also be called fixed currency exchange systems. Some pegged systems use a major currency, often the American dollar, as an anchor currency, meaning value fluctuations of all currencies are based on the fluctuations of the anchor currencies. How each currency fluctuates depends upon its set value relationship with the anchor currency.

A free exchange rate system can also be called a floating exchange rate system. In this type of exchange system, the price is set by market value, so it is heavily affected by economic changes. After the Euro was adopted, ERM was replaced with ERM-II, a similar semi-pegged currency system in which the Euro acts as the anchor currency. Like the original exchange rate mechanism, ERM-II has margins within which currency values are allowed to fluctuate. When currency values threaten to fluctuate outside the set margin, financial steps are taken to correct the fluctuation, including intervening in the currency market or offering loans.

The exchange rate is the price at which one country's currency can be exchanged for another country's currency. The market upon which currency is traded is called the foreign exchange market (FOREX), where currency is often traded as an investment. Investors trade in the FOREX market in a similar way they trade stock shares in the stock market, but rather than trading stock, they are buying and selling a country's currency. They can also invest in FOREX futures, which are contracts to buy and sell currency at a set price at a later date. The exchange rate mechanism used in many currency markets can help stabilize some of the risk common to investments in the foreign exchange market.

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