International Economics: The Fundamental Objects of European Monetary System - Essay Example

European Monetary System Introduction European Monetary System (EMS) is an arrangement by which the member countries in the European Union (EU) link their currencies to a common system, which prevents fluctuation in the exchange rate between one another. EMS was set up as a result of a resolution of the European Council on the 5th December, 1978. The system came into force on 13th March, 1979 according to a consensus between the central banks of the member countries. Originally, EMS was formed to stabilize foreign exchange and counter inflation among members. EMS is the forerunner of Economic and Monetary Union (EMU), which led to the establishment of Euro. The fundamental objectives of EMS are: (The European Monetary System) 1. To stabilize the exchange rates in order to rectify the existing instability 2. To reduce inflation 3. To prepare European Monetary Unification through cooperation. Thus, it was an arrangement/mechanism by which the exchange rate between the member countries in the European Union can be stabilized and inflation rate between the countries can be reduced. The working of the system is made possible by the interaction of three elements, which are given below (The European Monetary System) 1. The ECU: It is the common currency (called currency basket) 2. An exchange rate and Intervention Mechanism (ERM) 3. European Monetary Cooperation Fund (EMCF) History of EMS Currency stability had been a concern among major countries since Second World War and finally found a solution through a system of fixed exchange rate, called Bretton Wood System. Bretton Wood System was collapsed in the early 1970, but European leaders were keen to stabilize the exchange rate as opposed to another system called floating rate of return. It was organized in 1979 to stabilize foreign exchange and counter inflation among members. Periodic adjustments raised the values of strong currencies and lowered those of weaker ones, but after 1986 changes in national interest rates were used to keep the currencies within a narrow range. In the early 1990s the EMS was stressed by the conflicting economic policies and conditions of its members, especially the newly reunified Germany, and Britain permanently withdrew from the EMS In 1994 the European Monetary Institute was constituted as transitional step in establishing the European Central Bank (ECB) and a common currency. The ECB, which was established in 1998, is responsible for setting a single monetary policy and interest rate for the adopting nations, in conjunction with their national central banks. Late in 1998, Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain cut their interest rates to a nearly uniformly low level in an effort to promote growth and to prepare the way for a unified currency. On January 1, 1999 when the Euro was first launched in electronic form, it replaced the European Currency Unit (ECU) made up of defined quantities of twelve EU members at the rate of 'one ECU equal to one Euro', as of January 1, 1999. The national currency units of member states were automatically re-denominated to Euro on December 31, 2001. The working of EMS The main responsibility of EMS is to keep the exchange rate of member country's currencies within bands. In fact, the very aim of creating the EMS was the stabilization of the exchange rates of the participating countries by means of the Exchange Rate Mechanism (ERM). A maximum limit of 2.25 percentages was allowed for countries to fluctuate the exchange rate (European Monetary System, 2007) This was designed to help create stable commerce without the fear that sudden changes in the values of currencies would dampen trade and encourage the development of trading barriers between member states. "It also created a European Currency Unit (ECU) to be used as a unit of account. Although not a real currency, the ECU became the basis for the idea of creating a single currency - an idea that was realized with the launching of the Euro in 1999". Advent of Euro and its benefits "The advent of Euro is a manifestation of strong desire among the peoples of Europe for fostering an ever closer union and an unrelenting commitment to monetary integration. It is a logical complement to Europe's common internal market" (Khan Ahmad Aftab). The advent of Euro is expected to create great opportunities for the member countries and the populace. The goods and financial market in the future will be more vibrant and competitive and the new currency should go a long way for eliminating much inefficiency in the use of currencies in the member countries. In addition to that the transaction cost is also expected to reduce in the near future. "It will also result in the creation of a large and highly liquid Euro denominated market comprising national markets of 12 countries with a population of 306 million and accounting for around 20 per cent of world GDP and a similar proportion of world trade". (Khan Ahmad Aftab)The currency has also benefited the companies in the Europe to raise capital easily from the Euro bond and security market. Many economists have pointed out that the costs of European monetary union are going to be quite significant for some member countries. Unfortunately, at present the economic backdrop to advent of Euro and EMU is not as satisfactory as its promoters would have wished. Many European economies have experienced a set back recently owing to the controlling of inflation by ECB. Resultantly, the advent of Euro has brought in both positives and negatives to the region and to the world at large. For quite sometimes, Euro will become the central attraction of international monetary system. "At present the international monetary system is dominated by the US Dollar. More than 60 per cent of official currency reserves are held in US Dollars and although US continues to run a current a account deficit, around 80 per cent of external bank loans and 40 per cent of external bond issues are denominated in US Dollar"( Khan Ahmad Aftab) Conclusion The creation of European Monetary System, Economic and Monetary Union (EMU) and the introduction of the Euro are great events in economic history after World War II. The main reason for the popularity of the Euro is its large and expanding transaction size and the independent central bank which pursues price stability as its primary goal. However, dollar remains the key vehicle currency while the Euro has established itself as the second most widely used currency in the world. It was worth remarkable that the Euro depreciated against the dollar in the first three years after its introduction. Work Cited European Monetary System (2007) E U Facts. 4 December, 2008 Khan Ahmad Aftab. Islam Bank: European Monetary System and the Advent of Euro. 4 December, 2008. http://tyo.ca/islambank.community/modules.phpop=modload&name=News&file=article&sid=868 Mundell R.A. (1994). The European Monetary System 50 Years after Bretton Woods: A comparison between tow systems. 4 December, 2008 The European Monetary System. The European Monetary Union- Antecedents. 4 December, 2008 Read More