The 1992 European Exchange Rate Mechanism Crisis Case Study

The 1992 European Exchange Rate Mechanism Crisis - Case Study Example had exited the European exchange rate mechanism and that interest rates would remain unchanged at 12%, Italy was also affected by the crises on that same day and exited from the European exchange rate mechanism although it rejoined the union some years later.3 The UK crises can be linked to the failure of the regime to establish a crisis prevention and management mechanism within the union, if there existed a crisis management mechanism within the union it would have prevented the occurrence of the financial loss by the UK. In the ERM the currencies were floated and the exchange rate was determined by the market, the market forces dictate that if a currency is highly demanded then the currency will revalue and on the other hand if a currency is less demanded the currency will devalue. The crises in the UK can be linked to this market forces that determine the exchange rate of a currency, the government strategy at the time was to create demand for the pound by raising interest rates but this turned fruitless because speculators and investment banks were already aware of the strategy behind such a decision, speculators and investment banks therefore sold the pound to hold other currencies and this led to crisis in the UK which saw the devaluation of the pound. An expansionary monetary policy by a member of the European exchange rate would result into low interest rates among the other member countries, this would lead to the appreciation of all the other currencies, therefore there was a need to coordinate the policies among the member countries of the European exchange rate mechanism, the optimal coordination response to an aggregate demand shock by a member country was a set of small devaluations by the other countries, however this was not the case in this regime... The researcher of this case study concludes that the 1992 crises in the UK was as result of increased conflicts and lack of commitment among members of the European exchange rate mechanism. This led to frequent speculative attacks where the speculators and investment banks were aware of the strategies of individual central banks that led to great financial losses. The European exchange rate mechanism was initially formed to stimulate trade and investment among member countries of the union; it was also to be used as a tool that would help maintain a stable exchange rate among the currencies of member countries where countries were allowed a 2.25% fluctuation margin. However, interest rates and government policies were determined through market forces and were no longer influenced by external forces, this has led to a stable economy in the UK. In 1999 the European exchange rate mechanism was replaced by European exchange rate mechanism 2, the new mechanism seem to be better than the o riginal mechanism in that in this system currencies were allowed to float under a margin of 15% against the euro, this system is also better than the original because in that it uses the euro as the central unit of determining exchange rates. The European exchange regime would have been beneficial to member countries only that there was an increase in the level of conflict and decrease in coordination of policies, the regime led to great losses but was also beneficial in that it stimulated trade and investment among the member countries.