No. 228 - The Defence of Exchange Rates in the EMS: Instruments and Strategies, 1987-1993

The crisis of the EMS that culminated in August 1993 with the widening of the fluctuation band justifies further analysis of the working of the System in recent years. This paper covers the period from 1987 to 1993 and examines the use of the three instruments for defending exchange rates provided for in the Basle-Nyborg agreement, namely 1) exchange rate flexibility within the fluctuation band, 2) intervention in the foreign exchange market, and 3) interest rate changes. The first part reviews the different strategies that countries participating in the exchange rate mechanism adopted between 1987 and 1991, when such instruments were generally effective in countering speculative pressures and helped avoid realignments of the central rates. The second part focuses on the period between June 1992 and August 1993, which saw significantly greater tensions lead to five realignments in eight months and finally to the widening of the fluctuation band. During this period the use of exchange rate flexibility within the band provided positive results only for those countries which had successfully used it in the past; exchange market intervention was effective when coordinated; interest rate increases, perceived by the markets as inconsistent with monetary policy's domestic agenda, were insufficient to eliminate tensions.