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International money and finance - summary week7
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An in-depth summary of chapter 16 of the book International Finance (UVA-specific edition), including essential terms and pictures.
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CHAPTER 16 – THE EUROPEAN MONEATRY SYSTEM AND EUROPEAN MONETARY UNION16.1 INTRODUCTION
• Most important issues addressed by the EU and the EMU (European monetary union)
• 17 countries adopted euro as their currency
16.2 THE SNAKE IN THE TUNNEL
• Following the collapse of Bretton Woods system (1971)
o If the exchange rate was determined solely by market forces → not stable
• Degree of exchange rate stability + one currency
• EEC member (European economic community) set up Snake in the tunnel
o Mini Bretton Woods
o Member currencies could vary only by +- 1.125% against each other (the
snake)
o They could float by +- 2.25% against the US dollar (the tunnel)
o Snake system failed to produce the necessary degree of coordination of
economic policies and convergence of economic performance required for its
successful operation
16.3 THE BACKGROUND TO EMS
• Setting up of the EMS to replace the Snake
o For monetary zone stability
o To provide stable framework for European trade
• EMS consists of 3 main features
o 1. Exchange rate mechanism (ERM)
o 2. European currency union (ECU)
o Financing facilities
16.4 THE ERM
• 2 parts
o A gird of bilateral exchange rates bands between each of the member
currencies which defined obligatory intervention
o 2. An individual band of fluctuation for each currency against the ECU
▪ The ECU was a artificial currency based upon a calculation of weighted
basket of 12 EU currencies
• Bilateral exchange rate parities and obligatory intervention limits
o Grid of central exchange rates between each pair of currencies
o Could fluctuate +- 2.25% (Italy was allowed 6%)
o Then 15% for all currencies
o Within bilateral margins authorities could intervene if they wished – not
compulsory
o Any changes in the grid of central rates required mutual agreement
16.5 THE ECU ANF ITS ROLE AS AN INDICATOR OF DIVERGENCE
, • ECU → weighted basket of 12 member countries → indicator of divergence within
ERM
o Calculation of how a currency is doing in terms of other currencies
o ‘alarm bell’
• Did not necessarily worked as intended
o It was possible for a four high-weighted currencies in the ECU basket to
appreciate against weaker currencies in the system → but keep the same
central rate against each other
o Divergence thresholds not reached
16.6 FINANCING FACILITIES AND MONETARY COOPERATION
• Each member of the EMS deposited 20% of its gold dollar reserves with the EMCF in
exchange for the equivalent value in ECUs
• Each ECU issued was backed by dollars → it was hoped it will be used between EEC
central banks
• Later taken over by the European system of Central banks (ECSB) – 1998
• Important feature of EMS → credit facilities enabling deficit countries to defend their
exchange rate parities and manage transitory payment problems
o 1. Very short term financing
▪ Within 45 days at relevant money market interest rates
o 2. Short term monetary support
▪ Borrowing for duration of 3 months
o 3. Medium term financial assistance
▪ Loans for period of 2-5 years
16.7 AN ASSESSMENT OF THE EMS
• Economics were surprised by the resilience and relative success of EMS
• Exchange frate stability in the EMS
o Exchange rate realignments were frequent and substantial
o Between 1987 and 1992 → stability
o Germen reunification → high interest rates in Germany → other countries
too to remain parity
o Then periodic crisis (Italy, Ireland…)
o Both nominal and real exchange rate become less volatile for EMS currencies
+ greater convergence of inflation rates
16.8 THE EMS AS AN ANTI-INFLATION ZONE
• Germen inflation was generally lower than for the other countries in EU
• Participation in the EMS allowed France and Italy to reduce their inflation rates
substantially
• Anti inflation hypotheses → lack of support
16.9 INTERVENTION POLICY IN THE EMS
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