European monetary system

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European monetary system
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The European Monetary System (EMS) is a system of stabilizing exchange rates. Its aim was to create a currency stability zone in Europe and strengthen cooperation between member states in the area of monetary policy.

Establishment of EMS

The Treaty of Rome which established the European Economic Community did not establish a monetary union. Nevertheless, it contained general principles on currency cooperation (included in articles 105-109). They contained the principles of maintaining the balance of payments balance in the Member States and strengthening of their own currency, limiting the liberalization of capital transactions so that the common market would function properly and recommended consultation between Member States on exchange rate matters. The Monetary Committee was also appointed. There was no need to introduce a detailed regulation of the currency zone due to the smooth operation of the International Monetary Fund. Despite a well-functioning policy, the international currency crisis of the 1970s contributed to the collapse of the Bretton Woods currency system. This contributed to the abandonment of economic integration between member countries. The "currency snake" principle was the only result resulting from the pursuit of monetary integration. Due to the need to maintain the desired exchange rate and the related cash resources for intervention on currency markets, on December 5, 1978, eight European Union Member States (Germany, France, Italy, Belgium, the Netherlands, Luxembourg, Denmark, Ireland) created the European Currency System (EMS). He replaced the "currency snake" in force since the early 1970s. As a result of an agreement between the central banks of the member states, it was possible to implement it on March 13, 1979. The EMS was created by a directive adopted by the European Council. His task was to create a stable currency zone that would not include deep fluctuations in exchange rates. The creator of the system was Roy Jenkins.

Elements of the system

The main elements of the European Monetary System are:

  • ECU (European Currency Unit) - a European currency unit operating in the intangible sphere.
  • Exchange rate mechanism - initially the parity of currencies could fluctuate by ± 2.5% in relation to ecu, from August 1993. the range of fluctuations has been extended to ± 15%
  • Credit mechanism

The European Monetary System is the stage of creating Economic and Monetary Union. Operation of EMS since 1979. it allowed to significantly reduce exchange rate fluctuations both in comparison with the previous period as well as with exchange rates from outside the system, e.g. dollar, yen. Initially, the major problem was the frequent changes in central rates (during the first 8 years - 12 times).

EMS rules

The basic principle of operation is the stability of courses, i.e. the rates may fluctuate within a certain range around the reference (central) price, which can be changed by unanimous decision of system members.

Central banks that are part of the ESA are required to intervene in order to keep the exchange rate fluctuations within acceptable limits.

In order to obtain funds for these operations, they can grant each other loans under a special loan mechanism.

If, despite the intervention, it is impossible to maintain the exchange rate within a certain range, it may be necessary to change the central rate.

By enforcing monetary and economic policy to meet the requirements of the system, the EMS led to the approximation of economic results, especially the inflation rate in the member countries. It was an external source of discipline for countries with high inflation.

Crisis of the system from 1992.

Crisis of the system that took place in 1992. it resulted in the devaluation of the lira, the British pound, the Spanish peseta, the Portuguese eskudo and the Irish pound.

In addition, the participation of the lira and the British pound in the exchange rate mechanism was suspended.

The reason for the crisis was the accumulation of existing differences in economic results (mainly inflation), the specific policy of the central bank of Germany applying the policy of high interest rates, which forced the same actions in other countries. In addition, problems with the ratification of the Maastricht Treaty caused that stabilization was expected to cease.

The effects of this crisis were the extension of the range of permissible fluctuations to ± 15% (August 2, 1993), as well as the decision to create a supranational institution that will make decisions on monetary policy. The stronger the striving to create an economic and monetary union.

ECU (European Currency Unit)

As part of the European Monetary System, a new currency was created, called the ECU. As the central element of the EMS, it was introduced in 1979. In 1999, it was replaced by the euro. ECU was the so-called the currency of the basket and was the weighted average of the currencies of all countries belonging to the EMS. It played an important role. Every day, the Commission determined its value in each currency and then the rates were published in the "Official Journal of the European Communities". It served as a measure of value and a means of payment for the settlement of operations. Thanks to the ECU, one could find a reference in the exchange rate mechanism, find an indicator describing possible deviations of a given currency from others, specify the accounting units within the intervention and credit mechanisms and debt settlement unit between the bodies responsible for monetary matters in a given country. The ECU, through denominations of a given currency, was also used to calculate all payments in force within the Communities.

Examples of European monetary system

  1. Exchange Rate Mechanism (ERM): The Exchange Rate Mechanism (ERM) was the first element of the European Monetary System (EMS) and was introduced in 1979. It allowed for the fixing of exchange rates between participating currencies. This system was designed to help countries maintain relative stability in the exchange rates of their currencies and to reduce the risk of speculative attacks.
  2. European Currency Unit (ECU): The European Currency Unit (ECU) was the second element of the European Monetary System and was introduced in 1979. This was a virtual currency based on a basket of European currencies. The ECU was used as a reference currency and a unit of account for the European Union's internal transactions.
  3. Exchange Rate Stability Mechanism (ERSM): The Exchange Rate Stability Mechanism (ERSM) was introduced in 1987 and was designed to provide additional protection against exchange rate fluctuations. It allowed for the introduction of an exchange rate grid, where exchange rate fluctuations between participating currencies were limited to a certain percentage.
  4. European Monetary Cooperation Fund (EMCF): The European Monetary Cooperation Fund (EMCF) was established in 1989 to provide financial support to participating countries in the event of a balance of payments crisis. The fund was used to provide short-term credits to countries in need of foreign exchange reserves.

Advantages of European monetary system

The European Monetary System (EMS) had a number of advantages. These included:

  • Improved economic stability: The EMS provided a framework for cooperation between member states, allowing them to coordinate their monetary policies. This allowed them to reduce exchange rate fluctuations and promote economic stability.
  • Increased investment: The EMS allowed investors to have more confidence in the stability of their investments, as exchange rate fluctuations were reduced. This encouraged the flow of capital into the European economy.
  • Improved trade: The EMS facilitated trade between member states by providing a fixed, stable exchange rate system. This reduced the costs of currency conversion and allowed businesses to plan their operations more effectively.
  • Lower inflation: The EMS also helped to reduce inflation by allowing governments to pursue more stringent monetary policies. This allowed them to target inflation more effectively and keep prices under control.

Limitations of European monetary system

The European Monetary System (EMS) has several limitations which make it difficult to maintain exchange rate stability. These include:

  • The EMS was founded on the Exchange Rate Mechanism (ERM), which pegged the national currencies of participating member states to the European Currency Unit (ECU) at a fixed rate. This means that the exchange rate of each participating currency was fixed in relation to the ECU, creating an inflexible system.
  • EMS relied heavily on intervention by central banks to maintain the fixed exchange rate. This required close cooperation between member states, and even with such cooperation, the system was prone to speculation and instability.
  • The EMS was also limited by the fact that member states had different policies on monetary and fiscal matters, which could create imbalances in the system.
  • The system was also limited by the fact that it only applied to a limited number of countries. This meant that it could not provide stability to the entire European Union, allowing external shocks to affect its effectiveness.

Other approaches related to European monetary system

Apart from the European Monetary System, there are other approaches related to European monetary policy.

  • The European Central Bank (ECB) was established in 1998 as the main governing body of the European Union's monetary policy. It is responsible for setting interest rates, controlling inflation, and maintaining financial stability in the Eurozone.
  • The European Payments Union (EPU) was created in 1950 and was a precursor to the EMS. It operated as a clearing house for payments in Europe and helped to reduce currency risk.
  • The Exchange Rate Mechanism (ERM) was established in 1979 to reduce exchange rate volatility. It set a central rate for each currency and allowed for small fluctuations around that rate.
  • The Single European Act (1986) was an agreement between member states that aimed to create a single European market by eliminating barriers to trade and implementing common policies.
  • The Maastricht Treaty (1992) established the European Union and the common currency, the euro. It set out the criteria for membership in the Eurozone and provided the framework for economic and monetary union.
  • The Stability and Growth Pact (SGP) was established in 1997 and is a set of fiscal rules designed to ensure fiscal sustainability in the euro area.

In summary, the European Monetary System is one of several approaches related to European monetary policy. This includes the European Central Bank, the European Payments Union, the Exchange Rate Mechanism, the Single European Act, the Maastricht Treaty and the Stability and Growth Pact. These approaches have helped to ensure a stable and prosperous economy in Europe.