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 ¡V AD ¡V 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 1960¡¦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 1980¡¦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 community¡¦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...
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