European Monetary System

The European Monetary System was initiated in 1979, by an arrangement of the Member States of the European Economic Community to foster closer monetary policy co-operation between the Central Banks to manage intra-community exchange rates and finance exchange market interventions. The EMS was setup to adjust exchange rate, in order to establish closer monetary cooperation. The aim was to foster closer monetary cooperation and lead to a zone of monetary stability which was commencement in 1979 and worked until 1992; after that, the European monetary policy replaced the EMU. European Monetary System and attribution policy existed from 1 March 1979 and worked until at the year 1999 where exchange rates for Euro area countries were fixed by Euro in the new policy of EMU. European Monetary system was established in 1979 under the Roy Jenkins, President of the European Commission where most of the nations of European Economic Community linked their currencies to prevent large fluctuations relative to one another.
EMS was succeed by the Economic and Monetary Union of the European Union which was established in 1992, EMU represented a major step of integration in the EU economics and founded a common currency called Euro. Since 1979, the European Monetary System considered as the benefits conferred by a system of managed currencies where exchange rates was based on stable but adaptable exchange rate. The main objective of the EMS was to establish an Exchange Rate Mechanism to reduce exchange rate variability, achieve monetary stability in Europe and European Currency Unit was introduced in that time as a weight basket of all EEC currencies. The official EMS entered into force on March 13, 1979 with the participation of eight Member States.

Historical Timeline

The origin of the EMS started with former European Community, now European Union with the plan and initiatives by the leader of the European Community. In the end of 1960, in the Hague, the Heads of the Member State of EC agreed to move along the road to a full economic union. In 1969, the Heads of the State or Government of the Community had decided to create an economic and monetary union to complete into 1980. In response upon on the request, a group of experts, led by the Prime Minister and Minister of Finance of Luxembourg, Pierre Werner, elaborated the first plan in 1970. The Werner Committee was established prior to the Werner report which was published on 8 October 1970 and was the main successor of the EMS. On the basis of Werner report, the EEC moved to a single economy into three stages, with a fixed exchange rate but no single currency. On October 1972, the EEC's Paris summit agreed with the Werner plan and EEC currencies were linked through "the Snake". The Community adopted a resolution for instituting the European Monetary System on 5 December 1978 in Brussels by with the central idea of French President Valéry Giscard d'Estaing and German Chancellor Helmut Schmidt at European Council meeting. The main policies were to follow independent budgetary, monetary policies and the exchange rate. The well-structured form of EMS was welcome for the monetary and exchange policy outcome with the participation of the Member States. In 1988, a committee was set up under the Commission President Jacques Delors to make a new hard EMS that provided favorable starting conditions for the transition to Economic and Monetary Union. The Delors plan recommended a three-stage process lead to a single European currency under the control of a European Central Bank and it led to the adoption of Euro as a currency.


After the demise of the Bretton Woods system in 1971, most of the leaders of EC countries agreed in 1972 to maintain stable exchange rates by preventing exchange rate fluctuations of more than +/-2.25%, Italy exceptionally benefited from a wider +/-6% margin, these permissible was so-called ‘fluctuation bandwidths’. In this time, the EMS was a formal objective of stabilizing the currency rates and also maintain the competitiveness of its Member Countries, their plan was to achieve real and nominal exchange rates. The EMS was consisted of two main elements: one was about an agreement on a Community exchange-rate regime, another was about the decision to create a European Monetary Cooperation Fund. Moreover, the members of the EEC countries participated in Exchange Rate Mechanism because all of them were belonged to EMS policy, although Member States could opt out of the ERM if they had a valid reason. On March 1979, all idea were replaced by the European Monetary System, and the European Currency Unit was defined at the end.
The EMS has four basic functional arrangements are:
1.The ECU: With this arrangement, member currencies agreed to keep their foreign exchange rates within agreed bands with a narrow band of +/− 2.25% and a wide band of +/− 6%.
2. An Exchange Rate Mechanism : The main aim was to reduce exchange rate variability and achieve monetary stability.
3. An extension of European credit facilities : The aim was to provide enough credit facilities for a country who is ready to proceed to its convertibility in order to get loan easily.
4. The issue of a new reserve asset, to create European Monetary Cooperation Fund: created in October 1972 and allocated ECU to members' central banks in exchange for gold and US dollar deposits.
The EMS in many ways, was very similar to the Bretton Woods system in its policies and constituency. The similarities was that the role of European Monetary System was based on Deutsche Mark and the Bretton Woods system was based on U. S. Dollar. The European monetary system of the exchange-rate regime constituted a kind of Bretton Woods par value system on a European scale. Although no currency was designated as an anchor, the Deutsche Mark and German Bundesbank emerged as center of the EMS. Germany emerged as the dominant player within the EMS, set its monetary policy largely autonomously while other ERM members had attempted to converge on the German standard of Deutsche Mark which makes EMS highly asymmetrical. The German money supply played a role because of the lagged value of French money supply which were jointly insignificant. That was the way where German monetary policy transmitted into European Monetary System area, because of its relative strength of growth rate and the low-inflation policies of the bank, all other currencies were forced to follow its lead if they wanted to stay inside the system. The convergence rate was in German standard rather than the symmetry policy responded policy of it. Eventually, this situation led to dissatisfaction in most countries, and was one of the primary force behind the drive to a monetary union. The Deutsche Bundesbank determined the European monetary policy, fixed the reference level of the interest rates and the exchange rate in regard to dollar; although in the first ten months of 1979, the Deutsche Mark continued to rise both against the dollar within the snake.
Basically, there were two phase of the European Monetary System.
The flexible system of EMS : In this period, various adjustment of parity were taken place and Member Countries of the former EEC, had enjoyed a certain degree of autonomy in monetary policy by the given restriction on capital movements. Exchange rate were possible through certain adjustment also.
The rigid system of EMS : In this period, it was decided not to conduct readjustment despite significant changes in the real exchange rates of some countries. There was gradually shrink of monetary policy and readjustment were substantially absent.

1992 crisis

The early period of year 1990 started with crisis of the European Monetary System. There were some steps where EMS faced the crisis in whole period of EMS. After establishment of the European Single Market in 1986 where main theme was to remove the control on capital movements. The crisis started when the adjustment of the exchange rate was became problematic because of the control of capital movements. Periodic adjustments raised the value of strong currencies and lowered those of weaker ones, so in 1986 changes of national interest rates were used to keep the currencies within a narrow range. In the early 1990, the European Monetary System was strained by the differing economic policies and conditions of its members, especially the newly reunified Germany, and Britain permanently withdrew from the system in September 1992. The opt out of Danish referendum from EMU in 1992 and exchange rate of the currencies from weaker countries of EMS also stimulated the crisis. Speculative attacks on the French Franc during the following year led to the so-called Brussels compromise on August 1993 which established a new fluctuation band of +15% on each side for all the participating currencies. On August 1993, the ERM fluctuation bands were broadened from +/-2.25% to +/- 15% against central parity. The Bundesbank reduced the official interest rates and UK, Italy were affected by large capital outflows. Both Italy and UK between 1987 and 1992 were affected by a significant appreciation of the real exchange rate and then hit by the crisis; after the crisis, they planned to withdraw from ERM. In September 1992 and again in August 1993, the European Monetary System was hit by a major several crisis. However, the outcome as follows :
• On 13 September 1992 Italy decided to devalue Italian Lira by 7%
• On 16 September 1992 UK withdrew from ERM.
• On 17 September 1992 Italy withdrew from ERM.


European currency exchange rate stability has been one of the most important objectives of European policy makers since the Second World War. EMS provided a favorable starting condition for the transaction to Economic and Monetary Union. Between late 1982 and 1987, the different position on the money stability such as; the Dutch guilder remained quite stable in regard to the Mark, the Italian lira exhibited a sharp downward trend throughout the whole EMS period; finally the French franc, the Belgian franc, the Danish krona and the Irish pound switched from a trend of successive devaluations to stability. The Council of the European Union Ministers finalized in designing the EMS was the creation of a new monetary unit, the European Currency Unit. ECU was a composite of monetary unit of account which was based on basket for all EEC countries on specified amounts of each Community currency in the ECU was fixed, the weights of the various currencies change over time, as intra-European exchange rates fluctuated.
Two primary factors account for this:
During the first stage, there was very closer economic policy coordination happened by the Community and the liberalization of capital movements.

Stage II

The European Monetary System was no longer a functional arrangement in May 1998 as the Member countries fixed their mutual exchange rates when participating in the Euro. Its successor however, the ERM-II, was launched on 1 January 1999. The establishment of the European Monetary Institute. Member States are required to work to fulfill the five convergence criteria on inflation, interest rates, government deficit and debt, and exchange rate stability. In ERM-II, the ECU basket was discarded and the new single currency euro has become an anchor for the other currencies participated in the ERM-II. Participation in the ERM-II is voluntary and the fluctuation bands remain the same as in the original ERM, i.e. +15 percent, once again with the possibility of individually setting a narrower band with respect to the euro. Denmark and Greece became new members.

Stage III

The ERM-II is sometimes described as "waiting room" for joining the Economic and Monetary Union of the European Union. The third and final stage dominated by the introduction of the Euro. The Madrid European Summit on 15 and 16 December 1995 was set the start date for stage 3 on 1 January 1999, fixed the final euro conversion rates of the participated monetary units, and finished in 2002 with the introduction of euro notes and coins. In the EMU the actual currencies in the participating member states are replaced by euro banknotes and coins and entered into the Eurozone.


In the assessment of the credibility of the European Monetary System, Michael J Artis criticized that the EMS had low credible during the first eight years in the EMS history, the system demonstrated its resilience and had worked relatively non-smoothly. He also remarked that EMS was supposed to have contributed to improve the stability of the intra-EMS bilateral exchange rates but the improvement was less marked for effective rates and stability had weakened with the passage of time.
Another criticism led by Paul De Grauwe about the credibility and limited criteria of the EMS policy. In 1979, when EMS entered into force, GDP growth rate, investment growth rate, stability of exchange rate and interest rates declined dramatically. In 1980, there was a rise of unemployment after the EMS system. Both the average EMS the unemployment rate and the inflation differential had a significant effect on EMS credibility. The macroeconomic performance of the small EMS countries experienced larger declines in investment, whereas before the EMS they had experienced relatively faster growth rates.
About Exchange rate stability was quite powerless that was not much succeed in long term changes and real exchange rates. Whereas, real exchange rates are more important for investment, output, export and import decisions. It was only succeed in reducing short-term changes in bilateral exchange rates and nominal exchange rates. Indeed, inflation rates continued to differ widely within EMS. For example, Inflation rates of the nine members of the European Community vary 3 percent in Germany and 13 percent in only Italy.
Finally, the interest rates for both nominal and real interest rates increased substantially after 1979 and EMS provided a little benefit to its members in terms of monetary and financial stability. Furthermore, the degree of cooperation was too small to have significant benefits. The smaller EMS economics such as Belgium, Denmark and Ireland possess short term credibility but lack of long term credibility, on the other hand the highest long run credible found for Germany and the Netherlands, which both had low inflation record.
Additionally, Axel A. Weber also refers that the EMS was a de facto Deutsche Mark zone. Moreover, it was often called “tie one hands” because the policy adopted a fixed exchange rate which had short-run effects. The Bundesbank independently choose its monetary policy whilst all remaining EMS member countries by tied their hands on monetary policy and simply target their exchange rates to the German mark.