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European Monetary System 
Source: Encyclopedia of Banking & Finance (9h Edition) by Charles J Woelfel
(We recommend this as work of authority.)                  

The latest in the series of monetary arrangements over the years in the European Community (EC).  The European monetary system (EMS) officially came into effect on March 13, 1979.  The participating European countries were the following:

Belgium
Denmark
France
Federal Republic of Germany
Greece
Ireland
Italy
Luxembourg
The Netherlands
United Kingdom

(The United Kingdom is a member of the EMS, but does not participate in the intervention arrangements.)

The aim of the agreement creating the EMS was to foster "closer monetary cooperation leading to a zone of monetary stability in Europe.

The agreement consists principally in an intervention requirement on the part of each participant to limit exchange rate fluctuations, by the creation of the ECU (European currency unit, a "basket" of all ten EC currencies) as the center of the system, and by the enlargement of credit facilities already established in the EC.

The intervention mechanism requires that the member nations intervene the foreign exchange markets to prevent movements greater than 2.25% around parity in bilateral rates between participants.  Participating countries whose rates were previously floating against other participants' currencies are permitted to have movements in their bilateral rates of up to 6% around parity.  Italy decided to make use of this option.

There exists also a presumption that a participating country will take action when the value of its currency in terms of the ECU diverges from its central rate by more than a uniform percentage, the precise percentage for each country being adjusted to take account of the weight of its currency in the "basket."

Unlimited very short-term credit for intervention purposes continued in the same form as in the original snake arrangement, except that such credit can be extended for a somewhat longer period than before.  An initial supply of ECUs was issued by the European Monetary Cooperation Fund against deposits of 20% of both the gold and dollar reserves of participating countries.  These ECUs were to be used for the settlement of such intervention debts in accordance with agreed rules.  The short-term and medium-term facilities of the EC were substantially enlarged, and credit under the short-term facility can now also be granted over longer periods.  It is envisaged that ultimately all the credit facilities under the EMS will be consolidated in a European monetary fund (not to be confused with the erstwhile European fund of the EUROPEAN MONETARY AGREEMENT).

In addition to contributing to increased integration within the EC area, the principal objective of the EMS is to promote internal financial stability.  Participating countries in the earlier European common market arrangement, particularly those with small, open economies, have argued that the exchange rate stability gained through that arrangement has assisted their domestic economic policies and strengthened their foreign sectors.  The economies of those countries that previously allowed their rates to float but are now joining the arrangement have in the past followed a different path from those of the "snake" countries in response to differing circumstances and policies.  It is expected by the participants that the greater exchange rate stability gained by more concerted intervention policies will facilitate the task of harmonizing financial policies.

In view of the International Monetary Fund, these initiatives raise the question of what would be the requirements for a system in which exchange rate fluctuations were reduced and the rate changes that did occur were more consistently in line with long-term underlying trends.  Such a system requires orderly underlying economic and financial conditions in member countries.  Such conditions imply, inter alia, a closer approximation to reasonable price stability in member countries and a strong commitment by member governments to avoid future departures from price stability.  In an environment of this kind expectations could be stabilizing rather than destabilizing.  "The world is clearly still a long way from a system of that inflation not only leads to instability but also over the longer run adversely affects growth and employment opportunities constitutes an important first step on the road to a more stable international monetary system."

In June 1985, the European Council, composed of the heads of state and government of the EC countries, proposed certain reforms that included a specific timetable for the progressive liberalization of capital movements within the EC with a view to furthering convergence of economic policies within the EMS.  According to this proposal, all capital transactions will be liberalized by 1992.

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