European Monetary System
Introduction: The European Monetary System is an adjustable exchange rate arrangement set up in 1979 to foster monetary cooperation between the members of European Community. It was created in response to the collapse of Bretton woods agreement. The EMS's primary objective was to stabilize inflation and stop large exchange rate fluctuations between European countries. Later on, this formed part of a wider goal of achieving a greater convergence of financial and economic policies among member countries.
Evolution of European Monetary System:
(1) After the demise of Smithsonian Agreement, 6 western european nations agreed to maintain the parity values of their currencies within a band of ±1.125% as against ±2.25% described in the Smithsonian Agreement. This system came to be known as SNAKE.
(2) The SNAKE could not function smoothly for long. In order to bring greater degree of stability and to deepen the economic integration between the member countries, SNAKE was replaced by the " European Monetary System" in 1979.
(3) The European currency unit (ECU) was also established in 1979. ECU was created as the weighted average of the member country's currencies.
(4) EMS was based on the Parity grid system, wher the exchange rate between any two currencies was determined on the basis of their weights or share in ECU basket.
(5) During the initial years, a number of adjustments were made in the EMS. But due to differing economic conditions and policies of member nations, the parity grid experienced serious damage. In September, 1993 the band for fluctuations was widened to ±15%.
(6) In order to address the recurring problems in the EMS, the European union members met at Maastricht and signed The Maastricht Treaty in 1992. The member countries agreed to replace their individual currencies by a common currency by January 1, 1999 and also to harmonize their Fiscal, Monetary and Exchange rate policies to achieve greater convergence. The member countries were required to meet the following three criteria :-
(!) To keep the fiscal deficit to GDP ratio below 3%
(!!) To keep the Government debt to GDP ratio below 60%, and
(!!!) To ach6 high degree of price stability.
(7) The European Central Bank (ECB) was established in 1998 and it works in conjunction with national central banks to achieve price stability and is also responsible for the smooth conduct of monetary policy.
(8) Finally, on January 1, 1999 EURO was created and 11 out of 15 EU countries gave up their national currencies and adopted Euro. These 11 countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain. The European Monetary System (EMS) became European Monetary Union (EMU).
(9) In January, 2002 Euro notes and coins were issued and by the end of February, 2002 local currencies were completely replaced by EURO.
Stages in the development of European Monetary System:
Stage-I
It began on July 1, 1990 with free movement of capital in european community. During first stage, there was very closer, economic policy coordination in the EC and the Liberalization of capital movements.
Stage-II
It began on January 1, 1994 with the establishment of European Monetary Institute (EMI) which later on became ECB. During this stage, member states required to fulfill the five convergence criteria on inflation, interest rates, government deficit and debt, and exchange rate stability.
Stage-III
In third stage, commencing from 1997 but not later than January 1, 1999 members were required to fix the final Euro conversion rates. This stage was dominated by the introduction of the Euro and finished in 2002 with the introduction of euro notes and coins into the Eurozone. Currently there are 19 member countries in the Eurozone, which is officially known as Euro area.
Advantages of the EURO:
Today Euro is being perceived as a stable and trusted currency. The single currency has actually eliminated the exchange rate risk and lowered the transaction costs. This has proved useful for small time exporters who do not have to worry about hedging costs in various currencies, but manage only a single currency exposure. The Euro is the second most widely traded currency in the international capital markets. Around 50 countries use Euro as an anchor or referee currency in their exchange rate mechanism.
Criticism of the EMU:
(1) Under the EMS, exchange rates could only be changed if both, member countries and european commission were in agreement. This was an unprecedented move that attracted a lot of criticism.
(2) There was a fear of unemployment because of differing cultures of member nations and its significant impact on labour mobility.
(3) European sovereign debt crisis: The European debt crisis was a period when several European countries experienced the collapse of financial institutions, high government debt and rapidly rising bond yield spreads in government securities. The timeline if this crisis can be understood from the following image:-
(4) There is no protection against the economic problems being transmitted from troubled members.
(5) Particular challenges for monetary policy in the Euro area: These challenges arise from the sovereign debt-crisis, which is a major challenge for economic and monetary union.
a.) Heterogeneity in terms of growth, inflation, and competitiveness. There is a considerable growth gap between countries of euro area.
b.) Fiscal stabilization measures were necessary but they undermined the basic founding principles of the EMU.
c.) Economic governance in the euro area needs reforms.
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Please share your feedback/queries in comments section below.
Introduction: The European Monetary System is an adjustable exchange rate arrangement set up in 1979 to foster monetary cooperation between the members of European Community. It was created in response to the collapse of Bretton woods agreement. The EMS's primary objective was to stabilize inflation and stop large exchange rate fluctuations between European countries. Later on, this formed part of a wider goal of achieving a greater convergence of financial and economic policies among member countries.
Evolution of European Monetary System:
(1) After the demise of Smithsonian Agreement, 6 western european nations agreed to maintain the parity values of their currencies within a band of ±1.125% as against ±2.25% described in the Smithsonian Agreement. This system came to be known as SNAKE.
(2) The SNAKE could not function smoothly for long. In order to bring greater degree of stability and to deepen the economic integration between the member countries, SNAKE was replaced by the " European Monetary System" in 1979.
(3) The European currency unit (ECU) was also established in 1979. ECU was created as the weighted average of the member country's currencies.
(4) EMS was based on the Parity grid system, wher the exchange rate between any two currencies was determined on the basis of their weights or share in ECU basket.
(5) During the initial years, a number of adjustments were made in the EMS. But due to differing economic conditions and policies of member nations, the parity grid experienced serious damage. In September, 1993 the band for fluctuations was widened to ±15%.
(6) In order to address the recurring problems in the EMS, the European union members met at Maastricht and signed The Maastricht Treaty in 1992. The member countries agreed to replace their individual currencies by a common currency by January 1, 1999 and also to harmonize their Fiscal, Monetary and Exchange rate policies to achieve greater convergence. The member countries were required to meet the following three criteria :-
(!) To keep the fiscal deficit to GDP ratio below 3%
(!!) To keep the Government debt to GDP ratio below 60%, and
(!!!) To ach6 high degree of price stability.
(7) The European Central Bank (ECB) was established in 1998 and it works in conjunction with national central banks to achieve price stability and is also responsible for the smooth conduct of monetary policy.
(8) Finally, on January 1, 1999 EURO was created and 11 out of 15 EU countries gave up their national currencies and adopted Euro. These 11 countries were Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, The Netherlands, Portugal, and Spain. The European Monetary System (EMS) became European Monetary Union (EMU).
(9) In January, 2002 Euro notes and coins were issued and by the end of February, 2002 local currencies were completely replaced by EURO.
Stages in the development of European Monetary System:
Stage-I
It began on July 1, 1990 with free movement of capital in european community. During first stage, there was very closer, economic policy coordination in the EC and the Liberalization of capital movements.
Stage-II
It began on January 1, 1994 with the establishment of European Monetary Institute (EMI) which later on became ECB. During this stage, member states required to fulfill the five convergence criteria on inflation, interest rates, government deficit and debt, and exchange rate stability.
Stage-III
In third stage, commencing from 1997 but not later than January 1, 1999 members were required to fix the final Euro conversion rates. This stage was dominated by the introduction of the Euro and finished in 2002 with the introduction of euro notes and coins into the Eurozone. Currently there are 19 member countries in the Eurozone, which is officially known as Euro area.
Advantages of the EURO:
Today Euro is being perceived as a stable and trusted currency. The single currency has actually eliminated the exchange rate risk and lowered the transaction costs. This has proved useful for small time exporters who do not have to worry about hedging costs in various currencies, but manage only a single currency exposure. The Euro is the second most widely traded currency in the international capital markets. Around 50 countries use Euro as an anchor or referee currency in their exchange rate mechanism.
(1) Under the EMS, exchange rates could only be changed if both, member countries and european commission were in agreement. This was an unprecedented move that attracted a lot of criticism.
(2) There was a fear of unemployment because of differing cultures of member nations and its significant impact on labour mobility.
(3) European sovereign debt crisis: The European debt crisis was a period when several European countries experienced the collapse of financial institutions, high government debt and rapidly rising bond yield spreads in government securities. The timeline if this crisis can be understood from the following image:-
(4) There is no protection against the economic problems being transmitted from troubled members.
(5) Particular challenges for monetary policy in the Euro area: These challenges arise from the sovereign debt-crisis, which is a major challenge for economic and monetary union.
a.) Heterogeneity in terms of growth, inflation, and competitiveness. There is a considerable growth gap between countries of euro area.
b.) Fiscal stabilization measures were necessary but they undermined the basic founding principles of the EMU.
c.) Economic governance in the euro area needs reforms.
*************
Please share your feedback/queries in comments section below.
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