The European Monetary Union – (Back to School)


I have 395 posts in my blog fortunately came to know that lot of articles where complicated so I thought of doing the

The powerful European Central Bank [ E C B ] i...

series back to school, so that the post relating to the ongoing crisis can be linked and easily understood. Will try to post them as simple as possible. Starting today the formation of European Monetary Union (EMU). The formation of EMU took place in 3 stages :-

1) Formation of European Economic Community (EEC)
2) Establishment of European Monetary system (EMS)
3) Introduction of common currency EURO (EUR)

1) Formation of European Economic Community (EEC) : Six countries namely West Germany, Italy, France, Belgium, Holland and Luxembourg signed the treaty of Rome in 1958, agreeing to initiate step towards formation of the European common market. The step includes :

  • Progressive reduction in custom duty & Other restrictions between members so as to achieve a ‘zero’ tarrif level.
  • Creating a common schedule of duties tariffs & quotas when dealing with non members.
  • Increasing their specialization through migration of industries based on comparative advantage.
  • Synchronizing agriculture and transport policy
  • Removing all barriers on movement of goods, services, technology and labour between members.
  • Creating a common fund for retraining and redevelopment of labour.

The EEC succeeded in its goal of creating a common market by 1968.

2) Establishment of European Monetary system (EMS): Having achieved formation of custom union the EEC now proceeded with converging these economies. To achieve this they introduced the European Monetary system in 1969. This system was improvement over the Bretton wood arrangement and succeeded in providing long-term stability with flexibility & consistency . Lets try to explore the features of the EMS,

  • Creation of a Parity grid: Each member fixed a parity rate for every other member currency, there by creating an inter-loading grid of parities which provided for greater stability then the Breton wood system
  • Greater flexibility: This was achieved by providing a wider variation zone of +-2.25%, with a provision to increase the same +- 6%
  • Prohibition on unilateral parity change: In Brettonwood system countries could change their parities in consultation with IMF alone, resulting in frequent parity change and competitive devaluation. The EMS prohibited and change without a consensus of all members. From 1979-1992 there was no parity change in EMS assuring a greater consistency in currency valuations.
  • Dual intervention: In Brettonwood system the US didn’t participate in the intervention process. The onus of maintaining parity was always on the opposite member due to this intervention process was succesful at the lower end of variation zone but failed at the upper end due to inadequate resources. In the EMS when an exchange rate reach support point both the concerned member were obliged to intervene and support parity.This ensured that at least one Central bank had unlimited resources, at each end of variation zone. This feature guaranteed the success fo every interventions.
  • ECU as divergence indicator: The EMS created an artificial unit called ECU as a waited average unit using all member currencies, this unit was used to record borrowing between members and as a divergence indicator. Every currency in EMS has fixed relationship with the ECU when exchange rate between 2 member country reach an intervention point, the divergence against ECU was also verified, the currency showing greater divergence was identified for taking corrective action through policy changes. This ensured that repetitive intervention did not become necessary.

These features helped the member countries to achieve economic convergence in terms of parameters such as inflation, interest rates, BOP deficit etc.

3) Introduction of common currency EURO (EUR) : The member countries signed “The Maastricht Treaty” now under criticism, which became effective in feb 1992 in terms of this agreement following steps were initiated :

  • The EMI ( european monetary institute) was established to so as to function as the European Central Bank.
  • All capital control between members were abolished so as to integrate these economies.
  • On 31st Dec 1998 the exchange rate between all members were permanently frozen and the EURO was introduced on Jan 1 1999 the opening value of 1Euro = 1 ECU all ECU transactions where converted into EURO.
  • Currency notes and coins denominated in Euro introduced Jan 1 2002 and all previous currencies in circulation were withdrawn by June 30 2002.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s