European Monetary System
Encyclopedia
There are three stages of monetary cooperation in the European Union
European Union
The European Union is an economic and political union of 27 independent member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community and the European Economic Community , formed by six countries in 1958...
.
Background
European currency exchange rate stability has been one of the most important objectives of European policy makers at least since the Second World War.Two primary factors account for this:
- The history of exchange rate instability leading to social and economic instability, for example during the hyper inflation after the First World War in Germany or the competitive devaluations of the 1930s.
- The inter-dependence and "opennessOpen economyAn open economy is an economy in which there are economic activities between domestic community and outside, e.g. people, including businesses, can trade in goods and services with other people and businesses in the international community, and flow of funds as investment across the border...
" of European economies.
Stage I
European Monetary System (EMS) was an arrangement established in 1979 under the Jenkins European Commission where most nations of the European Economic CommunityEuropean Economic Community
The European Economic Community The European Economic Community (EEC) The European Economic Community (EEC) (also known as the Common Market in the English-speaking world, renamed the European Community (EC) in 1993The information in this article primarily covers the EEC's time as an independent...
(EEC) linked their currencies
Currency
In economics, currency refers to a generally accepted medium of exchange. These are usually the coins and banknotes of a particular government, which comprise the physical aspects of a nation's money supply...
to prevent large fluctuations relative to one another.
After the demise of the Bretton Woods system
Bretton Woods system
The Bretton Woods system of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid 20th century...
in 1971, most of the EEC countries agreed in 1972 to maintain stable exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
s by preventing exchange rate fluctuations of more than 2.25% (the European "currency snake
Snake in the tunnel
The snake in the tunnel was the first attempt at European monetary cooperation in the 1970s, aiming at limiting fluctuations between different European currencies...
"). In March 1979, this system was replaced by the European Monetary System, and the European Currency Unit
European Currency Unit
The European Currency Unit was a basket of the currencies of the European Community member states, used as the unit of account of the European Community before being replaced by the euro on 1 January 1999, at parity. The ECU itself replaced the European Unit of Account, also at parity, on 13...
(ECU) was defined.
The basic elements of the arrangement were:
- The ECU: A basket of currencies, preventing movements above 2.25% (6% for Italy) around parity in bilateral exchange rates with other member countries.
- An Exchange Rate Mechanism (ERM)
- An extension of European credit facilities.
- The European Monetary Cooperation FundEuropean Monetary Cooperation FundThe European Monetary Cooperation Fund is an institution and a fund established in 1973 by members of the European Exchange Rate Mechanism of the European Union to stabilise exchange rates. It was succeeded by the European Monetary Institute which is now part of the European Central Bank....
: created in October 1972 and allocates ECUs to members' central banks in exchange for gold and US dollar deposits.
Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank were unquestionably the centre of the EMS. Because of its relative strength, and the low-inflation policies of the bank, all other currencies were forced to follow its lead. This situation led to dissatisfaction in most countries, and was one of the primary forces behind the drive to a monetary union (ultimately the euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
).
Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s were used to keep the currencies within a narrow range. In the early 1990s the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain (which had initially declined to join and only did so in 1990) permanently withdrew from the system in September 1992. Speculative attack
Speculative attack
A speculative attack is a term used by economists to denote a precipitous acquisition of something by previously inactive speculators. The first model of a speculative attack was contained in a 1975 discussion paper on the gold market by Stephen Salant and Dale Henderson at the Federal Reserve Board...
s on the French Franc during the following year led to the so-called Brussels Compromise in August 1993 which established a new fluctuation band of +15%.
1992 crisis
For more information see Black WednesdayBlack Wednesday
In politics and economics, Black Wednesday refers to the events of 16 September 1992 when the British Conservative government was forced to withdraw the pound sterling from the European Exchange Rate Mechanism after they were unable to keep it above its agreed lower limit...
- On 13 September 1992 Italy decided to devalue Italian Lira by 7% (other currencies revalue of 3.5%: Lira devalues 3.5%)
- On 16 September 1992 UK withdrew from ERM.
- On 17 September 1992 Italy withdrew from ERM.
Stage II
The European Monetary System was no longer a functional arrangement in May 1998 as the member countries fixed their mutual exchange rates when participating in the euroEuro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
. Its successor however, the ERM-II
European Exchange Rate Mechanism
The European Exchange Rate Mechanism, ERM, was a system introduced by the European Community in March 1979, as part of the European Monetary System , to reduce exchange rate variability and achieve monetary stability in Europe, in preparation for Economic and Monetary Union and the introduction of...
, was launched on 1 January 1999. In ERM-II the ECU basket was discarded and the new single currency euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
has become an anchor for the other currencies participating in the ERM 2. Participation in the ERM 2 is voluntary and the fluctuation bands remain the same as in the original ERM, i.e. +15 percent, once again with the possibility of individually setting a narrower band with respect to the euro. Denmark
Denmark
Denmark is a Scandinavian country in Northern Europe. The countries of Denmark and Greenland, as well as the Faroe Islands, constitute the Kingdom of Denmark . It is the southernmost of the Nordic countries, southwest of Sweden and south of Norway, and bordered to the south by Germany. Denmark...
and Greece
Greece
Greece , officially the Hellenic Republic , and historically Hellas or the Republic of Greece in English, is a country in southeastern Europe....
became new members.
Stage III
The ERM-2 is sometimes described as "waiting room" for joining the Economic and Monetary Union of the European UnionEconomic and Monetary Union of the European Union
The Economic and Monetary Union is an umbrella term for the group of policies aimed at converging the economies of members of the European Union in three stages so as to allow them to adopt a single currency, the euro. As such, it is largely synonymous with the eurozone.All member states of the...
. In the EMU (stage III) the actual currencies in the participating member states are replaced by euro
Euro
The euro is the official currency of the eurozone: 17 of the 27 member states of the European Union. It is also the currency used by the Institutions of the European Union. The eurozone consists of Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg,...
banknotes
Euro banknotes
Euro banknotes are the banknotes of the euro, the currency of the eurozone and have been in circulation since 2002. They are issued by the national central banks of the euro area or the European Central Bank...
and coins
Euro coins
There are eight euro coin denominations, ranging from one cent to two euros . The coins first came into use in 2002. They have a common reverse, portraying a map of Europe, but each country in the eurozone has its own design on the obverse, which means that each coin has a variety of different...
; thus, entering the Euro Zone.