Explain why the European exchange rate mechanism (ERM) ran into problems in the 1990s

What will be an ideal response?

The ERM effectively linked EC exchange rates for two decades. However, problems began in 1990 with Germany's decision to speed up reunification. Economic conditions in East Germany were worse than expected, requiring that Germany make large investments in infrastructure and the environment. This resulted in a very large fiscal stimulus to the German economy. Such large expenditures were expected to have an inflationary impact, and so Germany's central bank raised interest rates to counteract that possibility. High interest rates in Germany made German financial instruments more attractive and caused capital to flow into Germany from the other EU countries. This resulted in the selling of other currencies to buy German marks (and then German bonds) and caused the pound, the franc, and other currencies to fall in value. Other countries could have raised interest rates to match Germany's, but since some of the countries, particularly the United Kingdom, were in recession, this would have been more contractionary to their economies. Faced with the choice between staying in the ERM and harming their own economies or dropping out of the ERM, countries were caught in a dilemma. France stayed in the ERM but went into recession. The United Kingdom abandoned the ERM and let the pound float freely. Spain shifted the center of the band. The band was later widened to 15 percent for countries that remained in the ERM.