Essay Networks

The European Economic Community (EC) was established by the Trety of Rome in 1957 with the intent of reaching full economic, monetary, and political union among its member countries. The primary goal of this European Community was to operate as a single market. In the beggining the European Community was consited of France, Germany, Italy, Belgium, Netherland and Luxembourg. Those countries were the first, because they had open economies. Nowadays, the members of the European Community are 15 countries.

Iin order for a common market to be established, the need of a common currency was essential. By that the transaction cost would be eliminated and the uncertainty of the exchange rates. So, in order for aal those to be accomplished, the European had to create a monetary system, which called, EMS (European Monetary System).

The EMS was created in order for the countries of EC to achieve financial cooperation and monetary stability. The EMS was created in March 1979 as an answer to the instability of the European economies, caused by flunctuations in the exchange rates. Its purpose was: 1) to establish monetary stability, 2) to overcome constraints caused by the interdependence of EU economies and 3) to aid the long-term process of European monetary integration. The mechanism the will help the success of the EMS was the Exchange Rate Mechanism (ERM), a voluntary system of semi-fixed exchange rates, based on ECU.

The ERM is a key instrument in order to achieve a single European currency administered by an EU central bank, which was the aim of the EMS

and and of the Treaty of Maastricht in 1992. So, the countries in that Treaty set a date in order to achieve these goals. The date was the January 1, 1999, but because the process of achieving this union is very complicated and not all countries belong to the ERM, they decide to expand the date for some counties until 2001. In order for the EU to prevent more countries from being forced out, in 1993 the ERM band was widened for all currencies except the Dutch Guilder and the Deutschmark. This action left only the Netherlands and Germany within the 2.25 percent band. By the april 1994, Belgium, Denmark, France, Ireland and Luxembourg were bac within the 2.25 percent band, but Spain and Portugal remain under pressure (Microsoft Encarta 98).

As we mentioned before, the ERM was based on the ECU. The ECU is a monetery unit based on a basket of all EC currencies. The number of units of each currency in the ECU is fixed, the weights of the various currencies change over time, as intra-European exchange rates fluctuate. The ECU also functions as a reserve instrument. It is issued by the European Monetary Cooperation Fund to the EMS central banks, in exchange for 20% of their gold reserves and U.S dollar reserves. The amount of ECU created as a result is adjusted every three monts to take account of changes in the level and variation of gold and dollar reserves (Kondonassis 4).

Some componets of the ERM is the availiability of credit financing. There are three financing facilities in the EMS: 1) the Very Short Term Fancing Facility (VSTF), 2) the Sort Term Monetary Support (STMS) and the Medium Term Financial Assistance (MTFA). The first two are administered by

central banks, the third by the EC Council of Ministers. ” The purpose of the VSTF is to finance obligatory intervention in EC curencies. VSTF consists of an unlimited credit line that the central banks participating in ERM open to each other, in their own currencies. The amounts drawn are expresed in ECU’s and carry interest. This financing is of very short duration, but it can be extended for three months subject to certain conditions and limits. With the consent of the creation a second extension of three months. The Short Term Monetary Support is a system of mutual credit for all the central banks of the EC. It was increased in volume and in duration on the creation of the EMS. The initial loan period is three months, but can be extended to a total duration of nine months. Finally, the Medium Term Financial Assistance is a system of mutual credit that EC meber states can grant each other for a period of two to five years. (Kondonassis 5)

The parity grid consist of the central rate, the bicentral rate and arginal intervation. Subject to agreement of all ERM participants, each member has a central rate. The central rate is expressed as the amount of theat nation’s currency equal to one ECU. The central rates are fixed andare revised only with a realignment. These rates are used in the parity grid to monitor currency fluctuatons relative to each other. The ratio of one country’s central rate to another’s forms the bicentral rate. From this bicentral rate, the value of this ratio is alowed to fluctuate up or down 2.25%. ehen the ratio reaches the allowable “margin”, action must be taken by both countries. This is called

marginal intervantion. The weaker currency’s central bank must sell the stronger currency, and the stronger currency’s central bank must buy the weaker curency.

The EMS experience

The variability of exchange rates before and after the implementation of the EMS is examined by Deravi and Metghalchi (1998). They compute an indicator of exchange rate variability for alternative measures of exchange rates. The measure they illustrated in their paper was monthly anerage absolute percent change (AAPC). For all the countries participating in the ERM, the AAPC dropped from 1.3% to 0.5%–a decrease of more than 50%. This evidence suggested that the bilateral exchange rate variability had been reduced since March 1979. (Kondonassis 5)

Coffey (1990) argues that the hoal of monetary stability has been served satisfactory by the EMS. At the beggining of the operation of the system the rates of inflation tended to rise but more recently they have tended to fall. Moreover, there has benn an expansion in the commercial use of the ECU. Bisinessmen view the ECU as a model of stability and a risk spreader. It is now among the top 5 currencies used for international loans.

Fratianni (1998) argues that the EMS has been successful in reducing nominal and real exchange rate variability. On the other hand, she says, the facts about inflation are more ambiguous. The achieved reduction in inflation rates turns out to be modest. The reduction in inflation among non-EMS countries was more signifigant when the entire post-EMS period is considered.

Pros and Cons of the system

The advantages of a system of permanently fixed exchange rates with free capital movements are well known and, nowadays, often repeated. If the system is credible, then the costs of information and transactions are reduced for international exchanges. Deficit finance must be restricted and country os regional policies must necessarily be harmonised, at least to the degree required by international capital movements that are unrestricted by exchange controls. Under such a system, harmonization reduces uncertainty about individual country policies, and the variability of real exchange rates is reduced. In addition, Mussa (1986) has shown that bilateral, ex post, real exchange rates are less variable under fixed (but adjusted) exchange rates.

The problem is an old one. The history of economics shows that many economists have been concerned by the variability of economic activity and prices in a fixed exchange rate system. The problem arises under fixed exchange rates because shocks to output require the adjustment of real interest rates, aggregate demand, and the domestic price level suficient to maintain the nominal exchange rate. A reduction in demand by one country lowers the exports of all countries. If the country experiencing the schock is a relatively large importer, then the shock is transmitted to other countries, raising or lowering their demand, output, prices, and employment.(Meltzer 1)

The Bretton Woods system sought to reduce this disadvantage of a fixed exchange rate system in two ways. First, surplus countries were supposed to lend to deficit countries when the deficits arose from transitory shocks. Second, the adjustment of exchange rates was to be reserved for permanent shocks. Thus, shocks to members of the system were to be reduced and the variability od output, prices, and employment was to be lowered for al countries while retaining some of the advantages claimed for a fixed rate system.(Meltzer 2)

A basic function of money and a monetary system is to reduce the costd of acquiring information and transacting. Variability of relative prices and exchange rates in one of the principal determinats of these costs; information costs increase eith variability. Inflation, particularly a variable rate of inflation, also raises the cost of acquiring information. Mussa’s (1986) data suggest that a fixed exchange rate system may lower information costs by redusing variability of real exchange rates, but Mussa did not investigate whether systematic differences in the variability of other relative prices or quantities work in the opposite direction. (Meltzer 2)

The problem for the European Monetary Union is to capture the gains from a common currency without incrring the losses from variable monetary policy, from inflation or deflation, from uncertainty about future prices and inflation, or from low credibility. One way to learn about the benefits of a common currency is to introduce a parallel currency that would be legal tender for private and public payments throughout the european Community. The parallel currency–call it the ECU- would be issued by a monetary authority on demand. The monetary authority would not have authority to change the quantity of ECUs in circulation except in response to deman. It

would purchase or sell ECUs against the currencies of member countries, on demand, at fluctuating exchange rates. (Meltzer 10)

EMS under pressure

The strength of the D-mark and the weakness of sterling threaten economic harm and political embarrassment all around. The ERM has come under pressure because in the past few weeks international investors have, in a big way, been selling dollars and buying D-marks. This has strengthen the German currency within the ERM and driven the system’s weaker currencies towards their permitted floors. This is niether harmful nor embarrassing in itself–but the required responce of policy may be. To defend the franc, Francehas raised its interest rates even though its domestic economy did not seem to warrant such a rise. Sterling is much weaker, so the British government may have to do the same–despite fears that Britain’s recovery may cool still further.

Bibliography

·         ”European Monetary system”, Microsoft Encarta 98 Encyclopedia.

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·         EMS under pressure. “Economist” 11/30/91. p16.

·         Meltzer, Allan. Some empirical findings on differences between EMS and non-EMS regimes: Implications for currency… “CATO journal. Fall 90. p455

·         Hamwi, I.S. The exchange rate mechanism’s in the European Monetary System. “International Advances in Economic Research” Aug95. p212.

·         Currencies on the verge of a nervous breakdown. “Economist” 5/2/92. p97.

·         Eichengreen, Barry. Mending Europe’s currency system. “Economist”. 6/5/93. p89

·         Lawday, David. Capsizing currencies. “US news & World Report”. 8/16/93. p43

·         Uncalm currencies. “Economist” 2/16/91. p12

·         Floating Europe. “Nation”. 8/23/93. p193

·         Money changes everything, “World press review” Nov92. p22

·         Giovannini, Alberto, “European Monetary System,” in The New Palgrave Dictionary of Money and Finance, P.Newman, M.Milgate,and J.Eatwell (eds.), 1992, MacMillan, 556-7

·         Giavazzi, Francesco and Alberto Giovannini, Limited Exchange Rate Flexibility; The European Monetary System, the MIT Press, 1989