The European Monetary System (EMS) refers to an arrangement established in 1979, whereby members of the European Economic Community (now the European Union) agreed to link their currencies to encourage monetary stability in Europe.
The EMS aimed to create a stable exchange rate for easier trade and cooperation among European countries through an Exchange Rate Mechanism (ERM). The ERM was based on the European Currency Unit (ECU) – a currency unit composed of a basket of 12 European currencies weighted by gross domestic product (GDP).
History of the European Monetary System
Beginning from the Second World War, the Bretton Woods System was used to try and maintain stability among major currencies. However, it was dropped in 1971. European countries then launched the European Monetary System in 1979, and leaders sought to achieve monetary stability through a stable exchange rate.
The EMS launched the European Currency Unit and the European Exchange Rate Mechanism in order to achieve the overarching goal of monetary stability and work towards the idea of a single market in Europe. It stayed in place until 1999 and was then succeeded by the European Monetary Union (EMU) and the Euro.
How Did It Work?
The European Monetary System mainly relied upon the ECU and the existing exchange rate mechanism then. Exchange rates were only allowed to deviate within a certain range from the fixed central point, which was determined by the ECU.
In the EMS, exchange rate fluctuations of member countries’ currencies were limited to 2.25% from the fixed central point, which was determined by the European Economic Community.
Goals of the European Monetary System
The European Monetary System aimed to achieve various macroeconomic goals:
Encouraging trade within Europe
Exchange rate stability among trading members
Controlled inflation within Europe
The 1992 Crisis
The EMS established a common monetary policy among member states and fixed the exchange rates. In 1992, Germany raised its interest rates to combat inflation – it placed upward pressure on the exchange rates of member countries at a time when they needed low interest rates and higher exports, resulting in a crisis.
Each country demonstrated different economic characteristics – some relied on cheap labor costs, while others were export-oriented economies – the increase in interest rates resulted in a different impact on each economy.
With exchange rates fixed, many countries experienced turmoil and ultimately eliminated their pegging system with the ECU, allowing exchange rates to float. Over time, the EMS changed the bandwidth for exchange rate volatility from +/- 2.25% to +/- 15%.
Benefits of the European Monetary System
1. Ensuring currency stability
The EMS ensured currency stability in Europe during times of international market volatility.
2. Working towards a single market
The EMS was considered an important step towards the establishment of the EU and the single market in Europe.
3. Unity in Europe
The EMS promoted political and economic unity across Europe at a pivotal time in European history.
Drawbacks of the European Monetary System
1. Fixed exchange rates
Fixed exchange rates affected different members of the EMS in different ways, which were not beneficial to all economies. It became evident in the 1992 crisis.
2. Common monetary policy
The EMS promoted a common monetary policy; therefore, raising or decreasing interest rates affected all economies differently – just like the exchange rate system.
The End of the European Monetary System
Following events in 1988, the EMS was set to undergo a three-stage reform that eased the transition to a common European monetary union. The first stage introduced free capital movements across Europe and was a part of the 1992 crisis. It continued functioning under the Maastricht Treaty, which was signed in 1992 and laid the foundation for the European Union.
The second and third stages came in 1998 and 1999 respectively, after the introduction of the Euro. The EMS and its exchange rate system were replaced by the adoption of the Euro and the formation of the European Central Bank, which has authority over the EU’s monetary policy.
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