European Monetary System

Article byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is European Monetary System (EMS)?

The European Monetary System or EMS was an arrangement created in 1979 that involved European Economic Community (presently known as European Union) members deciding to link their nation’s currencies to foster financial stability in Europe. This arrangement aimed to prevent significant exchange rate fluctuations and stabilize inflation between the countries.

European Monetary System

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This arrangement was based on the ECU or the European Currency Unit, which was a currency unit comprising a basket of twelve gross domestic product or GDP-based European currencies. Moreover, it depended on the exchange rate mechanism that existed at that time. The exchange rates could deviate only up to 2.25% from a fixed central point determined by the ECU.

Key Takeaways

  • The European monetary system refers to an arrangement consisting of different ECU members trying to foster economic stability throughout Europe.
  • Two key EMS objectives were encouraging trade and managing inflation within Europe.
  • A key feature of the European monetary system was the EMCF European Monetary Corporation fund. It was in control of the exchange rate mechanism and was responsible for issuing the European Currency Unit or ECU.
  • A key importance of the European monetary system was that it promoted both political and economic unity while ensuring currency stability throughout Europe when the international market experienced volatility.

European Monetary System Explained

The European monetary system refers to an exchange rate regime that was set up to encourage improved monetary policy cooperation among the members of the EC or European Community. The EMU, or European Economic and Monetary Union, succeeded the EMS, and the former introduced a common currency called the Euro. As noted above, this arrangement tried to stabilize the inflation rate and eliminate the high fluctuation in exchange rates between different European countries involved.

The countries established this arrangement to respond to the Bretton Wood Agreement’s collapse. The Bretton Wood Agreement came into existence in the second world war’s aftermath. It tried to bring stability to the economies and consolidate the international financial power among the different Western Allies.

Once the agreement ceased to exist, currencies started to float. As a result, there were significant fluctuations in the currencies’ market value. The fluctuations prompted the EC’s members to seek a new agreement concerning exchange rates to complement their customs union. This led to the establishment of EMS.

Some key features of the European Monetary System were as follows:

  • European Currency Unit: It was the monetary unit utilized in transactions involving the EC.
  • Exchange Rate Mechanism: Also known as ERM, it is the mechanism by which participating member states reach an agreement to maintain the fluctuations concerning currency within specific limits.
  • European Monetary Corporation Fund: A fund that issued ECU and supervised the ERM.

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History

Adjustments and uneven currency values that raised the stronger currencies’ values and lowered the values of the weaker ones marked EMS’s early years. Post 1986, the national interest rates were utilized to stabilize the currencies.

In the early 90s, EMS was in crisis. As a result of the varying political and economic conditions of the member countries, for example, Germany’s unification, Britain permanently withdraw from the arrangement. The withdrawal indicated the later demand for liberty from continental Europe.

During such times, there were increased efforts to form greater economic alliances and establish a common currency. In 1993, the Maastricht Treaty was signed by the majority of the European Community’s members. After one year, the EU established the European Monetary Institute, and in 1998, it became the ECB or European Central Bank. Its main responsibility was instituting a single interest rate and monetary policy.

At the end of the 90s, most EU countries cut their interest rates simultaneously to promote economic growth and prepare for the execution of the Euro. In 1999, the Euro, a unified currency, was created along with the establishment of EMU, which succeeded the EMS, as noted above.  

Objectives

The main goals of this arrangement were as follows:

  • Fostering trade within Europe
  • Controlling inflation within Europe
  • Stabilizing the exchange rate among the trading members

Crisis Of 1992

In 1992, Germany increased the interest rates to mitigate the impact of inflation — it put upward pressure on member countries’ exchange rates at a point in time when higher exports and low interest rates were necessary for them. That led to a crisis. Every country showed different economic features. While some nations were export-focused economies, others depended on cheap labor costs.

The surge in interest rates had a different effect on each economy. On account of the fixed exchange rates, various nations experienced turmoil. Ultimately, the countries abolished their pegging system using the ECU, enabling the exchange rates to float. With time, the EMS altered the bandwidth for the volatility of the exchange rate from +/-2.25 to +/-15%

Advantages And Disadvantages

Let us look at the benefits and limitations of EMS.

#1 – Advantages

  • The EMS was a crucial step towards forming the single market within Europe and the EU.
  • It promoted economic and political unity throughout Europe at a critical point in European History.
  • Another key importance European monetary system is that it ensured currency stability across Europe when the international market was subject to volatility.

#2 – Disadvantages

  • The common monetary policy promoted by the EMS decreased or increased the interest rates, impacting every economy differently.
  • The fixed exchange rates impacted multiple EMS members in various ways, which did not benefit all economies. This became evident during the crisis of 1992.

Frequently Asked Questions (FAQs)

1. Why European monetary system is successful?

It was successful as it managed to form a single market and ensured the stability of currency in Europe. Moreover, it managed to promote political and economic unity among the various members of the European Community.

2. What happened to the European Monetary System?

The EMS lasted for a couple of decades (1979-1999). The European Economic Monetary Union, or EU, replaced the arrangement in 1999, and the exchange rates for the Eurozone countries became fixed against the Euro, a new currency. Also, the exchange rate mechanism or ERM II replaced ERM simultaneously.

3. Why did European Monetary System fail?

A new crisis materialized for the arrangement in the early 90s. Varying political and economic scenarios surrounding the member nations, especially Germany’s reunification, caused Britain to withdraw from the arrangement permanently in 1992.

4. Who created The European Monetary System?

The initiation of this arrangement took place under the European Commission’s president, Roy Jenkins.

This has been a guide to what is European Monetary System. Here, we explain its objectives, history, crisis of 1992, advantages, and disadvantages. You can learn more about it from the following articles –

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