European Monetary System (EMS)

An arrangement initiated in 1979 where members of the European Economic

Community agreed to link their currencies

The European Monetary System (EMS) refers to an arrangement established in

1979, whereby members of the European Economic Community (now
the European Union) agreed to link their currencies to encourage monetary
stability in Europe.

The EMS aimed to create a stable exchange rate for easier trade and cooperation
among European countries through an Exchange Rate Mechanism (ERM). The
ERM was based on the European Currency Unit (ECU) – a currency unit
composed of a basket of 12 European currencies weighted by gross domestic
product (GDP).

History of the European Monetary System

Beginning from the Second World War, the Bretton Woods System was used to try
and maintain stability among major currencies. However, it was dropped in 1971.
European countries then launched the European Monetary System in 1979, and
leaders sought to achieve monetary stability through a stable exchange rate.

The EMS launched the European Currency Unit and the European Exchange Rate
Mechanism in order to achieve the overarching goal of monetary stability and
work towards the idea of a single market in Europe. It stayed in place until 1999
and was

then succeeded by the European Monetary Union (EMU) and the Euro.

How Did It Work?

The European Monetary System mainly relied upon the ECU and the existing
exchange rate mechanism then. Exchange rates were only allowed to deviate
within a certain range from the fixed central point, which was determined by the
ECU.
In the EMS, exchange rate fluctuations of member countries’ currencies were
limited to 2.25% from the fixed central point, which was determined by the
European Economic Community.

Goals of the European Monetary System

The European Monetary System aimed to achieve various macroeconomic goals:

 Encouraging trade within Europe

 Exchange rate stability among trading members
 Controlled inflation within Europe
The 1992 Crisis

The EMS established a common monetary policy among member states and fixed
the exchange rates. In 1992, Germany raised its interest rates to combat inflation –
it placed upward pressure on the exchange rates of member countries at a time
when they needed low interest rates and higher exports, resulting in a crisis.

Each country demonstrated different economic characteristics – some relied on

cheap labor costs, while others were export-oriented economies – the increase in
interest rates resulted in a different impact on each economy.

With exchange rates fixed, many countries experienced turmoil and ultimately
eliminated their pegging system with the ECU, allowing exchange rates to float.
Over time, the EMS changed the bandwidth for exchange rate volatility from +/-
2.25% to +/- 15%.

Benefits of the European Monetary System

1. Ensuring currency stability

The EMS ensured currency stability in Europe during times of international market
volatility.

2. Working towards a single market

The EMS was considered an important step towards the establishment of the EU
and the single market in Europe.
3. Unity in Europe

The EMS promoted political and economic unity across Europe at a pivotal time
in European history.

Drawbacks of the European Monetary System

1. Fixed exchange rates

Fixed exchange rates affected different members of the EMS in different ways,
which were not beneficial to all economies. It became evident in the 1992 crisis.

2. Common monetary policy

The EMS promoted a common monetary policy; therefore, raising or decreasing

interest rates affected all economies differently – just like the exchange rate
system.

The End of the European Monetary System

Following events in 1988, the EMS was set to undergo a three-stage reform that
eased the transition to a common European monetary union. The first stage
introduced free capital movements across Europe and was a part of the 1992 crisis.
It continued functioning under the Maastricht Treaty, which was signed in 1992
and laid the foundation for the European Union.

The second and third stages came in 1998 and 1999 respectively, after the
introduction of the Euro. The EMS and its exchange rate system were replaced by
the adoption of the Euro and the formation of the European Central Bank, which
has authority over the EU’s monetary policy.

Exchange Rate Mechanism (ERM) 

What Is an Exchange Rate Mechanism (ERM)?

An exchange rate mechanism (ERM) is a set of procedures used to manage a
country's currency exchange rate relative to other currencies. It is part of an
economy's monetary policy and is put to use by central banks.
Such a mechanism can be employed if a country utilizes either a fixed exchange
rate or one with a constrained floating exchange rate that is bounded around its
peg (known as an adjustable peg or crawling peg).

KEY TAKEAWAYS

 An exchange rate mechanism (ERM) is a way that governments can

influence the relative price of their national currency in forex markets.
 The ERM allows the central bank to tweak a currency peg in order to
normalize trade and/or the influence of inflation.
 More broadly, ERM is used to keep exchange rates stable and minimize
currency rate volatility in the market.
Understanding the Exchange Rate Mechanism
Monetary policy is the process of drafting, announcing, and implementing the plan
of actions taken by the central bank, currency board, or other competent monetary
authority of a country that controls the quantity of money in an economy and the
channels by which new money is supplied. Under a currency board, the
management of the exchange rate and money supply is given to a monetary
authority that makes decisions about the valuation of a nation’s currency. Often,
this monetary authority has direct instructions to back all units of domestic
currency in circulation with foreign currency. 

An exchange rate mechanism is not a new concept. Historically, most new

currencies started as a fixed exchange mechanism that tracked gold or a widely
traded commodity. It is loosely based on fixed exchange rate margins, whereby
exchange rates fluctuate within certain margins.

An upper and lower bound interval allows a currency to experience some

variability without sacrificing liquidity or drawing additional economic risks. The
concept of currency exchange rate mechanisms is also referred to as a semi-
pegged currency system.

Real World Example: The European Exchange Rate Mechanism

The most notable exchange rate mechanism occurred in Europe during the late
1970s. The European Economic Community introduced the ERM in 1979, as part
of the European Monetary System (EMS), to reduce exchange rate variability and
achieve stability before member countries moved to a single currency. It was
designed to normalize exchange rates between countries before they were
integrated in order to avoid any problems with price discovery.
The exchange rate mechanisms came to a head in 1992 when Britain, a member of
the European ERM, withdrew from the treaty. The British government initially
entered the agreement to prevent the British pound and other member currencies
from deviating by more than 6%.

Real World Example: Soros and Black Wednesday

In the months leading up to the 1992 event, legendary investor George Soros had
built up a monumental short position in the pound sterling that became profitable
if the currency fell below the lower band of the ERM. Soros recognized that
Britain entered the agreement under unfavorable conditions, the rate was too high,
and economic conditions were fragile. In September 1992, now known as Black
Wednesday, Soros sold off a large portion of his short position to the dismay of
the Bank of England, who fought tooth and nail to support the pound sterling.

The European exchange rate mechanism dissolved by the end of the decade, but
not before a successor was installed. The exchange rate mechanism II (ERM II)
was formed in January 1999 to ensure that exchange rate fluctuations between the
Euro and other EU currencies did not disrupt economic stability in the single
market. It also helped non-euro-area countries prepare to enter the euro area.

Most non-euro-area countries agree to keep exchange rates bound to a 15% range,
up or down, against the central rate. When necessary, the European Central Bank
(ECB) and other nonmember countries can intervene to keep rates in the window.
Some current and former members of the ERM II include Greece, Denmark, and
Lithuania.