The Collapse of the Erm

5.2 Problems in a fixed exchange rate system: The collapse of the ERM.

Examine the causes of the collapse of the ERM in 1992. In so doing demonstrate your understanding of the following: uncovered interest parity condition; international capital mobility; the difference between the nominal and the real exchange rate; how to analyze an asymmetric aggregate demand shock to the country setting monetary policy in a fixed exchange rate arrangement. What does the open economy imperfect competition model (ERU ÐŽV AD ÐŽV BT) predict would happen to inflation and unemployment in the countries that devalued in the crisis? Did it happen? Discuss.

The Exchange Rate Mechanism (ERM) was created in 1990, and was one of the key components to the integration of Europe. It followed the European Customs Union which was created in 1960ÐŽ¦s and more recently the creation of the single market in 1986, which removed the controls on cross-border capital flows. As well as these economic alliances, Europe also had its own European Parliament, the European Court of Justice and the European Commission. Monetary integration was seen as the final step.

In the late 1980ÐŽ¦s, Europe was in urgent need for a zone of monetary stability, the collapse of the Bretton Woods System 1971-1973 and its resulting volatility in financial markets heightened this urgency. Monetary Union was going to be the force that opened the door to political integration. The ERM was required due to the exchange rate volatility that threatened to wreak havoc with the competitive advantages of countries, and to erode the political support for the Customs Union. Importantly, the exchange rate fluctuations disrupted the operation of the Common Agricultural Policy, which was the European communityÐŽ¦s first concrete achievement. The membership of the single market (free capital mobility) meant that the exchange rate changes threatened to produce even larger shifts in the direction of trade.

However the ERM was not the great success that it had expected to be. Whilst the members of the ERM shared a common policy goal, which was achieving low inflation, the mechanism was successful. But following its creation, Europe has a large structure change which came in the form of the unification of Germany. This had three economic effects for Europe, strong domestic demand, fuelled by deficit spending, and a high interest rate, set by the Bundesbank to control high inflation. This asymmetric shock of the German unification meant that the interests of the members diverged, and the member countries disagreed on how the costs of adjustment should be shared, which undermined the ERM.

The massive fiscal expansion which was required to rebuild East Germany caused the Bundesbank to increase interest rates to control inflation. This was transmitted directly to the other countries whose currencies were pegged to the mark because their interest rates now rose in tandem with those in Germany. This is due to the Uncovered Interest Rate Parity Condition-if the interest rates were not the same in all ERM member countries then the countries with the higher interest rates would experience a boost in demand for their currency and the currency would appreciate. Whilst demand for the other countries would fall and their currencies would depreciate. This is dangerous because the currency value has to stay in the narrow bands.

The rise in the German interest rates is modelled by a negative demand shock for the other ERM member countries, whose unemployment was already above MRE conditions. This leftward shift of the AD curve led to a decline in Economic growth and a rise in unemployment. Speculators knew that high unemployment was politically unpopular and knew that there was tremendous force on the Governments of these countries to depreciate to promote growth, and avoid costly disinflations. These speculators choose to sell their pounds, and other ERM non-mark currencies, so these currencies depreciated, purely on the expectation of depreciation. These countries, except France, chose not to buy the home currency off the foreign exchange market but chose to leave the ERM. This was its collapse in 1992.

An asymmetric shock, a way of describing a recession which only affects some members of a group of trading countries, was part of what happened in the ERM. Germany, the country setting the monetary policy, had an increase in aggregate demand, while the rest of the ERM countries suffered a reduction. While this created a German boom, the rest of the countries found themselves in a recession due to the unemployment increases and the rise in the exchange rate.

The German economy had no particular reason to want to adjust; they had high output and employment, together with stable inflation at the EMU-wide level. It might have been suffering from current account deficits, but that didnÐŽ¦t pressure them into adjusting since they had no pressure from the foreign exchange market. On the other hand, the rest of the ERM countries wouldÐŽ¦ve preferred to adjust as soon as possible. To analyze this shock we can make the assumption that Germany acts like the rest of the world, like we do below.

To model what will happen to inflation and unemployment in a rest-ERM country as a consequence of devaluation under the pressure of rising German interest rates we make the following assumptions. Germany acts as the rest of the world. There is perfect capital mobility following the abolition of capital controls in 1986. The rest-ERM country is small and cannot influence world interest or inflation rate so must take them as given. World inflation rate remains constant, as do all other external factors (ceteris paribus). Initially, the