Principles of Macroeconomics: European Monetary System - Coursework Example

Principles of macroeconomics European Monetary System (EMS) was an arrangement to maintain stable exchange rates and prevent exchange rates fluctuations by more than desired levels. These exchange rates arrangements were made under the “Jenkins European Commission” in the year 1979. Most of the member Nations of the European Economic Community joined the arrangements by linking their currencies relative to one another. EMS was established with the efforts of those member countries who intended to formulate joint monetary policies through collective decisions of the member countries. It paved way for stability of currencies of the member countries. After the collapse of Bretteon Woods in early 70s, European leaders desired to maintain stable exchange rates rather than floating ones. Therefore European Monetary System was established. . This system replaced an already existing system whereby, in 1972, most of the European Union Countries agreed to maintain stability by preventing large exchange rate fluctuations. The European Community pursued for its economic strength and political integration since 1970. The European Monetary System served as a launching pad towards achievement of this goal. Due to its initial success in bringing stability in the exchange rates, this system was further strengthened in the year 1987. (Michael 2002, p-45-52) In wake of economic turbulence of 70s and fear of risks to capital movements under fluctuating exchange rates, European Community considered to establish European Monetary System (EMS). It had two main features: Formulation of Exchanged Rate Mechanism and creation of European Currency Unit (ECU). ECU was a composite currency of all the member countries and treated as ‘basket’ currency. In the year 1988 the Community members agreed to take further steps towards economic and monetary union. For this purpose the need for closer monetary and fiscal cooperation amongst the member states was felt. To meet this objective monetary union was proposed to be set up so that single currency could be created. Another rational behind establishment of the system besides other political motives was, to lower the transaction costs in trade with various countries and capital movements, eliminating the uncertainty in exchange rates, minimizing currency risks, encouragement of cross border investments and risks of heavy reductions in the value of such assets. As a number of European countries suffered from high inflation due to oil price hikes in mid 70s, EMS was also expected to provide and to some extent it provided the institutional structure like European Central Bank that helped fighting the inflation European Monetary System had following basic elements:- European currency Unit (ECU) Exchange rate Mechanism (ERM) European credit facilities Allocation of ECUs to the central banks of the member countries in exchange for US dollar and gold deposits through already existing European Monetary Cooperation Fund (Michael 2002, p. 102) European Currency Unit replaced the European Unit of Account in March, 1979 and became the basket currency and ‘European Unit of Account’ of member states of the European Community till the end of 1998. This currency was used in the financial transactions in between the other nations and Europe. Value of ECU was determined by weighted average of all the other currencies of member countries of European Union. The investors World over took advantage of it being a currency of almost all the member countries of European Union instead of relying on the currency of individual country. (Michael 2002, p. 65-95) Under the Exchange Rate Mechanism, exchange rates were allowed to vary under fixed exchange rate margins. Through this system currency fluctuations were contained within a given margin on either side. It helped in protecting the currencies from greater and abrupt exchange rate fluctuations. These margins varied as per speculative impacts over one and /or more than one currency. It will be interesting to note that United Kingdom entered in this mechanism in 1990 but soon withdrew because of currency speculations and felling into recession. Some of the writers of that period termed the ERM as “Eternal Recession Mechanism” rather than Exchange rate Mechanism due to its failure on certain economic fronts. In order to maintain the stability and improve trade between the European Community, Exchange Rate Mechanism was used. This mechanism helped in establishing a single market and stable money. The exchange rate mechanism was the main part of EMS. This mechanism made the member countries bound to keep their currency exchange rates within given bands. They were allowed to let their currencies fluctuate within 2.25 percent either way. This helped in stable trade as there was no fear of sudden fluctuations in the exchange rates.  EMS ultimately paved way for creation of European Currency Unit (ECU). By the 1980s the opinion of the member countries over this mechanism differed and divided and some of the member countries did not take part in this system which deepened the differences of Community over the issue. (Dominick 1996) There were numerous causes of its failure as researched and observed by various policy makers. It is viewed that the motives behind formulation of basis of the EMU were influenced by political considerations rather than merely economic. It lacked continent-wide political support which caused the crises and lead the system to collapse in 1992. In the year 1990, currency controls over cross border financial transactions, which were imposed under EMS in order to control speculative attacks over the currencies, were removed in order to ease the flow of funds. By removing these restrictions from capital movement the viability of European Monetary System stood undermined. In the year 1992, European Monetary System could not respond to certain monetary problems of member countries. After the re-unification of Germany in 1989, Government spending increased manifold that caused inflation resulting in high interest rates. Similarly United Kingdom also needed to increase the interest rates and reduce money supply because of recession that caused speculations about devaluation of sterling. Certain other member countries like Italy, Sweden, Spain and France also felt similar difficulties. In these circumstances such countries were forced to consider some alternative measures and/or abandon the fixed exchange rates in order to boost the trade and keep their foreign exchange reserves at desired levels. (Michael 2002) German’s Bundesbank and Deutschmark dominated the European Monetary System because of relatively low inflation policies of the bank and the currencies of all the other member countries were forced to follow the policies of the bank. It resulted in raising the values of some strong currencies and decreasing those of weak ones. French Franc came under severe speculative attacks. It caused great upset amongst most of the member countries and they were forced to think alternatives. It became one of the major causes behind the drive to establishment of a monetary union. In early 1990s the system (EMS) ultimately strained due to vast differences in the economic and monetary policies of the member countries. Germany and Britain withdrew from the system permanently in the last quarter of the year 1992. The Bundesbank proposed revaluation of central parities of EMS in the year 1989 which was resisted by France resulting in application of the only lever left to preserve the System i.e. interest rates, which were needed to be converged. This option also became impracticable due to wide recession in early 90’s. Tremendous pressures were felt in the United Kingdom, France and Italy to reduce the exchange rates. Some of the member countries in response to political pressures lowered the exchange rates at home in order to fight recession. It resulted in severe speculative attacks and fall of their currencies. They were, however, reluctant to officially devalue their currencies that could have reflected their retreat from the EMU goals. In these circumstances Sterling and Lira were pulled out if the system. (Dominick 1996) Researchers do argue both in favor of European Monetary System as also against it. Those who are in favor argue that the system helped a lot in ensuring currency stability at a time when the World markets were highly volatile. It also helped in establishing a single market. Those who oppose the system argue that fixed exchange rates are not economically viable because respective countries are forced to make all their economic and policies by keeping in view their impact over the exchange rates. International trading partners also avoid trade because of fixed exchange rates. Under this system it was presumed that fixed rates will suit all the member countries but this presumption proved to be false in its entirety as evident from the events of 1992. It couldn’t offer optimistic justifications in the long run. It therefore came under market pressures resulting in removal of certain currencies out of it and devaluation of certain others. References Michael, B, Charles, W 2002, Macroeconomics: A European Text, Oxford University Press, USA Dominick, S 1996, The European monetary system: Crisis and future, Springer link, viewed 28 May 2009, < http://ideas.repec.org/a/kap/openec/v7y1996i1p601-623.html> Read More