Summary
Summary of week 7 of the course International Money and Finance
- Module
- Institution
- Book
Summary of week 7 of the course International Money and Finance. Including Chapter 16.
[Show more]
Connected book
Book Title:
Author(s):
- Edition:
- ISBN:
- Edition:
More summaries for
-
International Finance
-
Summary of week 6 the course International Money and Finance.
-
Summary of week 5 of the course International Money and Finance. Chapter 8 and 10.
Seller
Followelinesteur
Reviews received
Content preview
Chapter 16: The European Monetary System and European Monetary UnionThe Snake in the Tunnel
Following the collapse of the Bretton Woods system in 1971, there was a great deal of concern at the
Community level that if the European Economic Community (EEC) countries allowed their exchange
rates to be determined solely by market forces there might be large and sudden changes in
international competitiveness associated with exchange rate movements that could undermine the
development of free trade within the Community. Indeed, it was feared that there might even be
deliberate competitive depreciations by some countries to gain trading advantage, which could result
in trade frictions and the emergence of protectionist pressures within the EEC and possibly threaten
the existence of the Community. In addition, following the Werner report of 1972, the member
countries of the EEC had set a target date for achieving European Monetary Union (EMU) by 1980. As
a result of these fears and a desire to introduce a single currency as well as some degree of exchange
rate stability, EEC members set up the so-called ‘Snake in the Tunnel’ which subsequently became
the plain ‘Snake’. The member currencies could vary by a maximum of ± 1.125 % against each other
(the Snake) they could float by ± 2.25 % against the US dollar (the Tunnel) as permitted by the
Smithsonian agreement. The Tunnel was demolished in March 1973 when the Snake currencies
decided on a joint float against the dollar. In April 1973 as part of the Snake system the European
Monetary Cooperation Fund (EMCF) was set up to provide credits and support for deficit countries.
In the end, the Snake system failed to produce the necessary degree of coordination of economic
policies and convergence of economic performance required for its successful operation.
The Background to the European Stability Mechanism (EMS)
On 17 June 1978, at a conference held in Bremen, six of the community countries committed
themselves to setting-up of the EMS to replace the Snake. The EMS aimed to provide a ‘zone of
monetary stability’ bringing back into the fold countries like Italy and France which had left the
Snake. Yao-su-Hu (1981) argues that the EMS was based upon a convergence of interest among the
EEC countries with regard to a common dollar problem. Under the Bretton Woods system, the dollar
was the major international reserve currency, used as a means of settlement between central banks,
for exchange market interventions and as a vehicle currency to denominate many international
transactions. He argues that the USA was free to run balance of payments deficits to supply the
world with the dollars it required. In return for this freedom, the USA was expected to avoid
undermining the purchasing power of dollars. When President Nixon suspended dollar convertibility
into gold in 1971 the USA had effectively abdicated its responsibility, causing serious economic and
financial losses for the Europeans. The dollar problem had many facets. As the dollar was pegged by
foreign central bank purchases of US dollars, this led to a rapid growth in the world money supply
and thereby contributed to worldwide inflation. Also, the depreciation of the dollar after suspension
of its convertibility meant huge losses for central banks who had purchased dollars under the Bretton
Woods system. Another motivation underlying the Bremen initiative was a desire to provide a stable
framework for the conduct of European trade. Since the adoption of the floating exchange rate in
1973, there had been very divergent inflation rates, economic growth and balance of payments
performance between the EEC economies. European policy-makers were concerned that such
divergent economic performance could threaten intra-EEC trade, and it was hoped that stabilizing
European currencies would lead to a greater convergence of economic performance and continued
growth of European trade. The EMS consisted of three main features. (1) The Exchange Rate
Mechanism (ERM); (2) The European Currency Unit (ECU);(3)Financing facilities. All members of the
EEC joined the EMS, though the UK did not initially participate in the ERM.
The ERM
The ERM consists of two parts:
1. A grid of bilateral exchange rate bands between each of the member currencies which
defined obligatory intervention.
, 2. An individual band of fluctuation (threshold) for each currency against the ECU. The ECU was
an artificial currency based upon a calculation of a weighted basket of 12 European
currencies. If a currency moved too much against the ECU basket it would lead to the
expectation that the authorities of that currency would take policy measures designed to
bring it back within its ECU threshold.
The bilateral exchange rate aspect of the ERM consisted of a grid of central exchange rates between
each pair of currencies in the ERM. Originally each currency could fluctuate a maximum ± 2.25 % of
its assigned bilateral central rate against another member currency of the ERM. But there were some
exceptions, which lead to a exchange rate crisis where the maximum was ± 15 %. Within the bilateral
margins authorities could intervene if they wished, though it was not compulsory. Intra-marginal
intervention was carried out in either EMS or non-EMS currencies. Once two currencies reached a
bilateral exchange rate margin the authorities of the two currencies were obliged to intervene or
take economic policy measures to keep the currencies within their bilateral limits. At the outset of
the system, the intention was that obligatory intervention should take place in the relevant EMS
currencies rather than in US dollars. An important feature of the ERM was that any changes in the
grid of central rates required ‘mutual agreement’. In practice, this meant that parity changes were
taken by the finance ministers of the currencies participating in the ERM.
The ECU and its Roel as an Indicator of Divergence
A key component of the ERM was the ECU which, between 1979 and 1999, was a weighted basket of
12 member currencies; the 12 currencies being those of the 12 members prior to the entrance of the
three new members. The ECU acted as an ‘indicator of divergence’ within the ERM> Once a bilateral
margin was reached, requiring compulsory intervention, a question arose as to which authority was
responsible for intervention. The ECU was nothing more than a calculation of how a currency was
doing against a basket of other European currencies. In effect, the ECU was supposed to act as an
alarm bell – once a currency crossed its divergence threshold against the ECU the alarm bell is
triggered and the authorities of the diverging currency were expected to take measures to bring its
currency back into line. Such action could consist of a change in interest rates and/or in the
monetary/fiscal policy pursued by the country. The high-weight currencies were assigned lower
divergence threshold than low-weight currencies.
Financing Facilities and Monetary Cooperation
Another key feature of the EMS was that each member of the EMS deposited 20% of its gold dollar
reserves with the EMCF in exchange for the equivalent value in ECUs; the idea being that authorities
use ECUs rather than dollars for their exchange market interventions. It was hoped that ECUs would
be extensively used for settlements between EEC central banks. The responsibility of the EMCF were
taken over by the European Monetary Institute in January 1994 and by the European System of
Central Banks (ESCB) in 1998. An important feature of the EMS was that members had access to
credit facilities enabling deficit countries to defend their exchange rate parities and manage
transitory balance of payments problems. These credit facilities were as follows:
Very short-term financing: a credit facility which participating central banks granted to one another.
Short-term monetary support: the funds available under this credit facility were intended to meet
financing needs in instances of temporary balance of payments problems.
Medium-term financial assistance: this facility provided credits for participating countries
experiencing or seriously threatened with difficulties with their balance of payments over the
medium term.
An Assessment of the EMS
Despite much initial skepticism, many economists were surprised at the resilience and relatively
successful operation of the EMS. Against this, however, the system was characterized by periods of
The benefits of buying summaries with Stuvia:
Guaranteed quality through customer reviews
Stuvia customers have reviewed more than 700,000 summaries. This how you know that you are buying the best documents.
Quick and easy check-out
You can quickly pay through credit card for the summaries. There is no membership needed.
Focus on what matters
Your fellow students write the study notes themselves, which is why the documents are always reliable and up-to-date. This ensures you quickly get to the core!
Frequently asked questions
What do I get when I buy this document?
You get a PDF, available immediately after your purchase. The purchased document is accessible anytime, anywhere and indefinitely through your profile.
Satisfaction guarantee: how does it work?
Our satisfaction guarantee ensures that you always find a study document that suits you well. You fill out a form, and our customer service team takes care of the rest.
Who am I buying these notes from?
Stuvia is a marketplace, so you are not buying this document from us, but from seller elinesteur. Stuvia facilitates payment to the seller.
Will I be stuck with a subscription?
No, you only buy these notes for £2.56. You're not tied to anything after your purchase.
Can Stuvia be trusted?
4.6 stars on Google & Trustpilot (+1000 reviews)
72042 documents were sold in the last 30 days
Founded in 2010, the go-to place to buy revision notes and other study material for 14 years now
Recently viewed by you
