European Monetary System

After the break down of the Bretton Woods System in 1973, several European countries attempted various mechanisms to fix their exchange rates to each other. While allowing their currencies to float against the dollar, these European countries tried progressively to narrow the extent to which they let their currencies fluctuate against each other. Six members of the European Economic Community (EEC), including France and Germany, jointly floated their currencies against the dollar. The currencies of the participating countries were allowed to fluctuate in a narrow band with respect to each other (1.125% on either side of the parity exchange rate), and the permissible joint float against other currencies was also limited (to 2.5% on either side of the parity). This fixed exchange rate system that arose concurrently with the fall of the Bretton Woods System was called the “snake” as this gave the currency movement the look of a “snake”.

In 1979, eight European countries created a formal system of mutually fixed exchange rates, called the European Monetary system (EMS). They fixed their exchange rates relative to each other, floating jointly against the dollar. The system was quite similar to the Bretton Wood System, with the exception that instead of the currencies being pegged to the currency of one of the participating nations, a new currency was created for the purpose. It was named the European Currency Unit (ECU) and was defined as a weighted average of the various European currencies. Each member had to fix the value of its currency in terms of the ECU. This had the effect of pegging these currencies with each other. Each currency could vary against the ECU and against other currencies within a certain band on either side of the parity rate thereby forming a “parity grid”. When EMS was first set up, a currency was allowed to deviate from parities with other currencies by a maximum of plus or minus 2.25%, with the exception of Italian lira, for which a maximum deviation of plus or minus 6% was allowed. In September 1993, however the band was widened to a maximum of plus or minus 15%. When a currency is at the lower or upper bound, the central bank of both countries are required to intervene in the foreign exchange markets to keep the market exchange rate within the band. To intervene in the exchange markets, the central bank can borrow from a credit fund to which member countries contribute gold and foreign reserves.

Initially there had been capital controls that limited the ability of private citizens to trade in foreign currencies. This was to prevent speculators from starting a currency crisis. These restrictions were later relaxed in 1987.

Since the EMS members were less than fully committed to coordinating their economic policies, the EMS went through a series of realignments. Despite the recurrent turbulence in the EMS, European Union members met at Maastricht (Netherlands) in December 1991 and signed the Maastricht Treaty. Ac­cording to the treaty, the European Union will irrevocably fix exchange rates among the member currencies by January 1, 1999, and subsequently introduce a common European currency, replacing individual national currencies. The European Central Bank, to be located in Frankfurt, Germany, will be solely responsible for the issuance of common currency and conducting monetary policy in the European Union. To pave the way for the European Monetary Union (EMU), the member countries of the European Union agreed to closely coordinate their fiscal, monetary, and exchange rate policies and a achieve a convergence of their economies.

On January 1 2002, 12 European countries finalized their monetary union. This meant that they had a common central bank in Frankfurt in Germany, at which all 12 countries had to agree on a common monetary policy. Eleven European countries adopted a common currency called the euro, voluntarily giving up their monetary sovereignty. With the launching of the euro on January 1, 1999, the European Monetary Union (EMU) was created. The EMU is a logical extension of the EMS, and the Eu­ropean Currency Unit (ECU) was the precursor of the euro. As the euro was introduced, each national currency of the euro-11 countries was irrevocably fixed to the euro at a conversion rate as of January 1, 1999. National currencies such as the French franc, German mark, and Italian lira are no longer independent currencies. Rather, they are just different denominations of the same currency, the euro.  Once the changeover is completed the legal-tender sta­tus of national currencies will be canceled, leaving the euro as the sole legal tender in the euro countries. Monetary policy for the euro countries will be conducted by the European Central Bank (ECB) headquartered in Frankfurt, Germany, whose primary objective is to maintain price stability. The independence of the ECB is legally guaranteed so that in conducting its monetary policy, it will not be unduly subjected to political pressure from any member countries or institutions. The national central banks of the euro countries will not disappear. Together with the European Central Bank, they form the European System of Central Banks (ESCB). The tasks of the ESCB are threefold: (1) to define and implement the common monetary policy of the Union; (2) to conduct foreign exchange operations; and (3) to hold and manage the official foreign reserves of the euro member states. Al­though national central banks will have to follow the policies of the ECB, they will continue to perform important functions in their jurisdiction such as distributing credit, collecting resources, and managing payment systems.

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