European Monetary System

European Monetary System (EMS)

A system adopted by European Community members with the aim of promoting stability by limiting exchange-rate fluctuations. The system was originated in 1979 by the nine members of the European Community (EC). The EMS comprised three principal elements: the European Currency Unit (ECU), the monetary unit used in EC transactions; the Exchange Rate Mechanism, ERM, whereby those member states taking part agreed to maintain currency fluctuations within certain agreed limits; and the European Monetary Cooperation Fund, which issues the ECU and oversees the ERM. The 1992 Maastricht Treaty provided for the move to Economic and Monetary Union (EMU), including a European Monetary Institute to coordinate the economic and monetary policy of the EU, a European Central Bank (ECB) to govern these policies, and the presentation of a single European currency.

European Monetary System

A system established in 1979 whereby most member states of the European Economic Community linked their currencies to each other in anticipation of monetary integration. The first stage of the EMS was the European currency unit, then the ERM I, and, finally, the introduction of the euro and the ERM II. The European Monetary System also called for greater extension of credit between European countries. Among the methods the EMS used included the relative synchronization of national interest rates.

European Monetary System (EMS)

the former institutional arrangement, established in 1979, for coordinating and stabilizing the EXCHANGE RATES of member countries of the EUROPEAN UNION.

The EMS was replaced in January 1999 by the exchange rate arrangements of the ECONOMIC AND MONETARY UNION (EMU).

The EMS was based on a FIXED EXCHANGE RATE system and the European Currency Unit (ECU), which was used to value, on a common basis, exchange rates and which also acted as a reserve asset to be used by members, alongside their other INTERNATIONAL RESERVE holdings, to settle payments imbalances between themselves.

European Monetary System (EMS)

the former institutional arrangement, established in 1979, for coordinating and stabilizing the EXCHANGE RATES of member countries of the EUROPEAN UNION (EU). The EMS was replaced in January 1999 by the exchange rate arrangements of the ECONOMIC AND MONETARY UNION.

The EMS was based on a FIXED EXCHANGE RATE mechanism and the EUROPEAN CURRENCY UNIT (ECU), which was used to value, on a common basis, exchange rates and which also acted as a reserve asset that members could use, alongside their other INTERNATIONAL RESERVE holdings, to settle payment imbalances between themselves. The EMS was managed by the European Monetary Cooperation Fund (EMCF).

Under the EMS ‘exchange rate mechanism’ (ERM), each country's currency was given a fixed central par value specified in terms of the ECU, and the exchange rate between currencies could move to a limited degree around these par values, being controlled by a ‘parity grid’ and ‘divergence indicator’. The parity grid originally permitted a currency to move up to a limit of 2.25% either side of its central rate. As a currency moved towards its outer limit, the divergence indicator came into play requiring the country's central bank to intervene in the foreign exchange market or adopt appropriate domestic measures (e.g. alter interest rates) in order to stabilize the rate. If in the view of the EMCF the central rate itself appeared to be overvalued or undervalued against other currencies, a country could devalue (see DEVALUATION or revalue (see REVALUATION) its currency refixing it at a new central parity rate.

The European Currency Unit, unlike other reserve assets such as GOLD, had no tangible life of its own. ECUs were ‘created’ by the Fund in exchange for the inpayment of gold and other reserve assets and took the form of book-keeping entries recorded in a special account managed by the Fund. The value of the ECU was based on a weighted ‘basket’ of members’ currencies.

Initially, the UK declined to join the Exchange Rate Mechanism (ERM) but did so eventually in October 1990, establishing a central rate against the German DM (the leading currency in the ERM) of £1 = 2.95 DM. The UK withdrew from the ERM in September 1992 after prolonged speculation against the pound had pushed it down to its ‘floor’ limit of 2.77 DM, rejecting the devaluation option within the ERM in favour of a market-driven ‘floating’ of the currency (see FLOATING EXCHANGE RATE SYSTEM). In August 1993, after the French franc came under pressure, ERM currency bands were widened to 15%. These episodes, together with the earlier withdrawal of the Italian lira from the ERM, illustrate one of the major drawbacks of a fixed exchange rate system, namely, the tendency for ‘pegged’ rates to get out of line with underlying market tendencies, so fuelling excessive speculation against weak currencies.