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Introduction to the European Monetary System

The purpose of the European Monetary System (EMS), which was established in 1979, is to stabilize exchange rates between the currencies of member states in the European Union.

In the past years, the EMS has helped to strengthen cooperation among the countries of Europe in the area of monetary policy. It has also had a disciplinary effect on the monetary and financial policies of the EU member states.

All members of the EU are in the EMS, and most of them are in the Exchange Rate Mechanism (ERM) as well.

The ERM fixes the central rates for each currency.

Since 2 August 1993, currency market rates have been allowed to fluctuate up to a maximum of 15 percent either side of the central rate. If greater fluctuations are imminent, the national central banks are obliged to buy or sell the cu rrencies affected and thus stabilize the exchange rates. If the economic trend so requires, the central rates can be adjusted by means of a unanimous decision of the EU finance ministers and central bank governors. Obviously, the EMS binds only the ex change rates of the participating countries. The rates with other currencies, such as the dollar or the yen, fluctuate freely on the currency markets.

Within the EMS there is a European Currency Unit (ECU) which serves as a link and unit of account between member currencies. The ECU is not a currency in itself, however, but a "basket" of the currencies of 12 of t he presently 15 EU states which contains, for instance, 62 German Pfennigs, 1.33 French Francs and 152 Italian Lira. These amounts are no longer adjusted. Under the Treaty on European Union, the composition of the ECU basket was frozen.

In December 1991 a treaty was concluded in Maastricht by the then 12 EG states pursuant to which a European Economic and Monetary Union is to be completed by 1999 at the latest. Before they can participate in the final stage, states must fulfill strict criteria (stable prices and exchange rates, low interest rates, sound public finances). Participants in the Monetary Union have undertaken to transfer their monetary sovereignty to a politically independent European Central Bank, the foremost objective of which will be to maintain price stability. At the EU summit in Madrid in December 1995, it was resolved that the new European currency be called the "Euro". The new Eurocash is to replace the nati onal currencies in the year 2002.

European Monetary Union will have numerous advantages. German exporters will no longer be at a disadvantage vis--vis their European competitors in the European internal market and in the markets of non-EU states as a result of devaluation of their compet itors' currencies. Companies will have a reliable basis on which to plan; tourists will not have to exchange currency, which means their holidays will be cheaper; the European currency can become a more important world reserve currency than is presently t he case; and competition intensified by greater transparency in prices will improve the efficiency of the European economies. This will make it possible to safeguard present jobs and create new ones.

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Exchange Rate Mechanism (ERM)

The Exchange Rate Mechanism, which forms the core of the EMS, provides a means for stabilizing exchange rates between member states of the ERM.

Each ERM currency has a specified fixed central rate of exchange relative to the ECU basket. Bilateral central rates as well as the current upper and lower fluctuation limits are derived from the ECU central rates. The fluctuation limits also serve as man datory intervention limits. Central banks can however - if they so wish - intervene before bilateral rates reach their intervention points.

When the EMS was established in 1979, all then member states of the EU except the UK joined the ERM. Spain joined the ERM in 1989 and Portugal in 1992; Greece is not yet a member. The UK joined in 1990 but was forced to withdraw from the ERM, along with I taly, in autumn 1992.

The fluctuation margins were ± 2.25 per cent except for the Italian lira, UK pound, Spanish peseta and Portuguese escudo, which were assigned margins of 6 per cent around their central rates. In 1990 the Italian lira was assigned the narrow margins. Following the currency crisis of August 1993, the margins for all ERM currencies were widened to ± 15 per cent. Now, the only exchange rate with margins of ± 2.25 per cent is that between the Deutschemark and the Dutch guilder as per bilateral a greement.

A change of a central rate in the ERM requires preparation of the matter in the EU's Monetary Committee and negotiations with the finance ministers of the EMS member states and with the EU Commission. The last change in the parity grid took place in March 1995 when the Spanish peseta was devalued by 7 per cent and the Portuguese escudo by 3.5 per cent.

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European Currency Unit ECU

Use of the ECU began in 1979. The ECU basket included a specified amount of each EU member currency. The amounts were based on the respective strengths of the economies involved. The composition of the ECU basket was frozen in March 1993 so that the curre ncies of new members, including Finland, are not included. This is, however, of no significance because a central rate for a currency can be defined against both the ECU and each of the other currencies, even though that currency is not included in the ECU basket.

The ECU basket, ie the official ECU, is not a freely traded currency. It is instead a payment and accounting unit for payment transactions between central banks. The ECU will be removed from use when the euro is launched on 1 January 1999.

In addition to the official ECU there is the private ECU created by commercial banks, which is freely exchanged in the various markets. Private ECUs are used on the basis of contracts in which the parties agree that payment is to be made in ECUs.

The values of the official and private ECUs can differ from each other although they generally change in the same direction. The official ECU is the weighted average of the currencies included in the ECU basket whereas the value of t he private ECU is determined by market supply and demand like any other commercially used currency.

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Cooperative central bank financing facilities

The cooperative central bank financing facilities are administered by the European Monetary Institute (EMI). There are three of these:

  • Very Short-Term Financing (VSTF)
  • Short-Term Monetary Support (STMS)
  • Medium-Term Financial Assistance (MTFA).

Very Short-Term Financing is the ERM central banks' mutual intervention financing facility, through which a central bank can automatically obtain loans for supportive selling when the rate approaches a fluctuation limit. The loans are granted by the centr al bank whose currency is approaching its 'strong' limit. Loans for interventions well within the fluctuation margins are always subject to approval of the lending central bank.

Short-Term Monetary Support is designed for financing temporary balance of payments deficits; any EMS member state can apply for this type of support.

Medium-Term Financial Assistance can be granted to an EMS state for 2-5 years in case of serious balance of payments problems.

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ECU basket weights in September, 1996.
in percent

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Because of the roundings the sum of the weights does not add up to 100.0.

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Faculty Advisor : Prof. Jeffrey Hart
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Last updated : 6.18.97