INTRODUCTION

European Monetary System, arrangement by which most nations of the

European Union (EU) linked their currencies to prevent large fluctuations relative
to one another. 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 European Monetary System was strained by the differing economic
policies and conditions of its members, especially the newly reunified Germany,
and Britain permanently withdrew from the system.
In 1994 the European Monetary Institute was created as transitional step in
establishing the European Central Bank (ECB) and a common currency. The ECB,
which was established in1998, 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.
At the beginning of 1999, the same EU members adopted a single currency,
the euro, for foreign exchange and electronic payments. (Greece, which did not
meet the economic conditions required until 2000, subsequently also adopted the
euro.) The introduction of the euro four decades after the beginings of the
European Union was widely regarded as a major step toward European political
unity. By creating a common economic policy, the nations acted to put a damper
on excessive public spending, reduce debt, and make a strong attempt at taming
inflation. However, the budget-deficit ceilings established in the process of
introducing the euro have been violated by a number of countries since 2001, in
part because of national government measures to stimulate economic growth.
In 2003, EU finance ministers, faced with the fact that economic downturns
had put France and Germany in violation of the ceilings, temporarily suspended the
pact. The European Commission challenged that move, however, and the EU high
court annulled the finance ministers' decision in 2004. Euro coins and notes began
circulating in Jan., 2002, and local currencies were no longer accepted as legal
tender two months later.
The European Currency Unit (ECU), which was established in 1979, was the
forerunner of the euro. Derived from a basket of varying amounts of the currencies
of the EU nations, the ECU was a unit of accounting used to determine exchange
rates among the national currencies. Of the European Union members Denmark,
Great Britain, and Sweden that did not adopt the euro when it was introduced
perhaps the most notable is Britain, which continues to regard itself as more or less
separate from Europe. In all three nations there has been strong public anxiety that
dropping their respective national currencies would give up too much
independence. Danish voters rejected adoption of the euro in a referendum in 2000;
the vote was seen as strengthening euro opponents in Britain and Sweden. Of the
12 EU members admitted since 2004, only one Slovenia has adopted the euro.
The global financial crisis of 20089 revealed by 2010 a number difficulties
in the common monetary system. In the crisis and its aftermath nations could not
resort to expanded government deficits as a means to revive their economies;
instead, soaring deficits forced significant recessionary government austerities on
Greece, Ireland, Spain, Portugal, and other nations. Lacking national currencies,
these nations also could not resort to devaluation. The budget shortall and
government debt in Greece in particular strained the monetary union and the
stability of the euro as eurozone nations (Germany especially) agreed only with
difficulty on measures designed to assist Greece and support the euro. The delay in
acting contributed to an increase in the cost of aiding Greece, and forced EU
nations, along with the International Monetary Fund, to pledge $950 billion in loan
guarantees and other measures to aid financially troubled eurozone nations and
support the euro. Ireland and Portugal also ultimately were forced to seek
international financial assistance. In Dec., 2010, EU nations agreed to establish the
European Stability Mechanism (ESM), a permanent fund to aid financially
troubled member nations that came into being in Oct., 2012.
As the eurozone financial crisis continued into 2011, threatening Spain and Italy as
well, EU governments agreed to strengthen the powers and increase the aid funds
and to additional efforts, including significant losses on Greek debt, to stabilize
Greek finances. In Dec., 2011, an EU accord was reached (with Britain as the only
clear nonparticipant) to more strictly enforce the deficit and debt ceilings required
of eurozone and other EU members through national constitutional amendments
and EU sanctions. The agreement was codified in a treaty signed in Mar., 2012, by
all EU nations except Britain and the Czech Republic; later that month, the amount
of funds available to aid troubled nations was increased. Spain and Cyprus
subsequently announced plans to seek international financial assistance. In July,
2012, EU nations agreed to establish a financial supervisory authority under the
ECB to oversee the eurozone's largest banks and also to allow bailout aid directly
to those banks (instead of to them through their national governments) once the
oversight body was created. By mid-2013 the ongoing euro zone crisis had led to a
prolonged recession and record average unemployment in the region (and
extremely high unemployment in Greece and Spain).
How did the European Monetary System work?
The most important part of the EMS was the Exchange Rate Mechanism.
This committed all member states governments to keep their currency exchange
rates within bands. This meant that no countrys exchange rate could fluctuate
more than 2.25% from a central point. 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 realised with the launch of the Euro in
1999.
Definition:-
A 1979 arrangement between several European countries which links their
currencies in an attempt to stabilize the exchange rate. This system was succeeded
by the European Monetary Union (EMU), an institution of the European Union
(EU), which established a common currency called the euro.





ORIGIN OF EUROPEAN MONETARY SYSTEM
The EMS was launched in 1979 to help lead to the ultimate goal of EMU
that had been set out in the Werner Report (1970). Since World War II, attempts
had been made to maintain currency stability amongst major currencies through a
system of fixed exchange rates called the Bretton Woods System. This collapsed in
the early 1970s. However, European leaders were keen to maintain the principle of
stable exchange rates rather than moving to the policy of floating exchange rates
that was gaining popularity in the USA. This led them to create the EMS. It was
not an entirely successful move because, firstly, it posed many technical
difficulties in setting the correct rate for all member states, and secondly, some
members were less committed to it than others. Britain didnt join the ERM until
1990 and was forced to leave it in 1992 because it could not keep within the
exchange rate limits. The project, however, continued: under the Maastricht Treaty
(1992), the EMS became part of the wider project for EMU that was developed
during the 1990s. When the Euro came into being in 1999, the EMS was
effectively wound up, although the ERM remained in operation.

The first appeal for a European currency prior to the 1929 crash:-
On 9 September 1929 the German politician Gustav Stresemann asked the
League of Nations the following question "Where are the European currency and
the European stamp that we need? Six weeks later, on 25 October, the New York
Stock Exchange experienced its "Black Friday": the international economic crisis
began. It caused enormous economic upheaval internationally, business closures
and an unprecedented level of unemployment.
The States responded to the crisis with a policy of "beggar-thy-neighbour",
taking deflationary measures to boost export competitiveness and introducing tariff
barriers for products imported from abroad. This policy made the economic crisis
worse. While in the short term it was beneficial to the State concerned, in the long
term it had serious economic consequences: inflation, falling demand, rising
unemployment and slower growth in world trade.
The end of the Second World War: a new start:-
In 1944, while the Second World War was still laying waste to Europe, a
conference on the restructuring of international financial and monetary relations
took place at Bretton Woods in the United States. Over forty countries participated:
on 22 July 1944 they signed the Bretton Woods Agreements. These agreements
lay down rules and procedures governing the world economy. They led to the
establishment of the International Bank for Reconstruction and Development
(BIRD, which has now become part of the World Bank) and the International
Monetary Fund. Furthermore, the Bretton Woods Agreements put in place the gold
standard monetary system. This system provides stable exchange rates based on
gold which becomes the reference standard. Only the US dollar is convertible into
gold and the other currencies are indexed to the dollar.
The world underwent profound changes after the Second World War. The
experiences of war gave rise to an awareness that international cooperation was
crucial to avert further suffering. The United Nations (UN) was thus set up in
1945. In Europe, the first foundations for what would later become the European
Union were laid by three Treaties bringing together six signatory States (Germany,
Belgium, France, Italy, Luxembourg and the Netherlands):
The Treaty establishing the European Coal and Steel
Community (ECSC), signed on 18 April 1951;
The Rome Treaties, i.e. the Treaty establishing the European Economic
Community (EEC) and the Treaty establishing the European Atomic
Energy Community (EURATOM), signed in March 1957.
Creation of Economic and Monetary Union:-
At the summit in The Hague in December 1969, the Heads of State and
Government defined a new objective of European integration: Economic and
Monetary Union (EMU). A high-level group chaired by Pierre Werner, Prime
Minister of Luxembourg, was thus given the task of drawing up a report on how
this goal might be reached by 1980.
The Werner group submitted its final report in October 1970. It envisaged
the achievement of full economic and monetary union within ten years according
to a plan in several stages. The ultimate goal was to achieve full liberalisation of
capital movements, the total convertibility of Member States currencies and the
irrevocable fixing of exchange rates. The report therefore envisaged the adoption
of a single European currency as a possible objective of the process, but did not yet
regard it as a goal in itself. Furthermore, the report recommended that the
coordination of economic policies be strengthened and guidelines for national
budgetary policies drawn up.
In March 1971, although being unable to agree on some of the key
recommendations of the report, the Six gave their approval in principle to the
introduction of EMU in several stages. The first stage, involving the narrowing of
currency fluctuation margins, was launched on an experimental basis and did not
entail any commitment regarding the continuation of the process.
The collapse of the Bretton Woods system and the decision of the US
Government to float the dollar in August 1971 produced a wave of instability on
foreign exchanges which called into serious question the parities between the
European currencies. The EMU project was brought to an abrupt halt.
In March 1972 the Six attempted to impart fresh momentum to monetary
integration by creating the "snake in the tunnel": a mechanism for the managed
floating of currencies (the "snake") within narrow margins of fluctuation against
the dollar (the "tunnel"). Thrown off course by the oil crises, the weakness of the
dollar and the differences in economic policy, the "snake" lost most of its members
in less than two years and was finally reduced to a "mark" area comprising
Germany, the Benelux countries and Denmark.
Creation of the European Monetary System (EMS):-
Efforts to establish an area of monetary stability were renewed in March
1979, at the instigation of France and Germany, with the creation of the European
Monetary System (EMS), based on the concept of fixed, but adjustable exchange
rates. The currencies of all the Member States, except the United Kingdom,
participated in the exchange-rate mechanism.
The principle was as follows: exchange rates were based on central rates
against the ECU (European Currency Unit), the European unit of account, which
was a weighted average of the participating currencies. A grid of bilateral rates was
calculated on the basis of these central rates expressed in ecus, and currency
fluctuations had to be contained within a margin of 2.25 % either side of the
bilateral rates (with the exception of the Italian lira, which was allowed a margin of
6 %).
Over a ten-year period, the EMS did much to reduce exchange-rate
variability: the flexibility of the system combined with the political resolve to bring
about economic convergence, achieved sustainable currency stability.
With the adoption of the Single Market Programme in 1985, it became
increasingly clear that the potential of the internal market could not be fully
exploited as long as relatively high transaction costs linked to currency conversion
and the uncertainties linked to exchange-rate fluctuations, however small,
persisted. Moreover, many economists denounced what they called the "impossible
triangle": free movement of capital, exchange-rate stability and independent
monetary policies were incompatible in the long term.
I ntroduction of the EMS:-
In June 1988 the Hanover European Council set up a committee to study
economic and monetary union under the chairmanship of Jacques Delors, the then
President of the European Commission. The other members of the committee were
the governors of the national central banks, who were therefore closely involved in
drawing up the proposals.
The committee's report, submitted in April 1989, proposed to strengthen the
introduction of the EMU in three stages. In particular, it stressed the need for better
coordination of economic policies, rules covering national budget deficits, and a
new, completely independent institution which would be responsible for the
Union's monetary policy: the European Central Bank (ECB).
On the basis of the Delors report, the Madrid European Council decided in
June 1989 to launch the first stage of EMU: full liberalisation of capital
movements by 1 July 1990.
In December 1989 the Strasbourg European Council called for an
intergovernmental conference that would identify what amendments needed to be
made to the Treaty in order to achieve the EMU. The work of this
intergovernmental conference led to the Treaty on European Union, which was
formally adopted by the Heads of State and Government at the Maastricht
European Council in December 1991 and signed on 7 February 1992.
The Treaty provides for the EMS to be introduced in three stages:
Stage No 1: (from 1 July 1990 to 31 December 1993): the free movement of
capital between Member States;
Stage No 2: (from 1 January 1994 to 31 December 1998): convergence of Member
States economic policies and strengthening of cooperation between Member
States national central banks. The coordination of monetary policies was
institutionalised by the establishment of the European Monetary Institute (EMI),
whose task was to strengthen cooperation between the national central banks and
to carry out the necessary preparations for the introduction of the single currency.
The national central banks were to become independent during this stage;
Stage No 3: (underway since 1 January 1999): the gradual introduction of the euro
as the single currency of the Member States and the implementation of a common
monetary policy under the aegis of the ECB. Transition to the third stage was
subject to the achievement of a high degree of durable convergence measured
against a number of criteria laid down by the Treaties. The budgetary rules were to
become binding and a Member State not complying with them was likely to face
penalties. A single monetary policy was introduced and entrusted to the European
System of Central Banks (ESCB), made up of the national central banks and the
ECB.
The first two stages of EMU have been completed. The third stage is
currently underway. In principle, all EU Member States must join this final stage
and therefore adopt the euro (Article 119 of the Treaty on the Functioning of the
EU). However, some Member States have not yet fulfilled the convergence
criteria. These Member States therefore benefit from a provisional derogation until
they are able to join the third stage of EMU.
Furthermore, the United Kingdom and Denmark gave notification of their
intention not to participate in the 3
rd
stage of EMU and therefore not to adopt the
euro. These two States therefore have an exemption with regard to their
participation in EMU. The exemption arrangements are detailed in the protocols
relating to these two countries annexed to the founding Treaties of the EU.
However, the United Kingdom and Denmark reserve the option to end their
exemption and submit applications to join the 3
rd
phase of EMU.
Currently, 17 of the 27 Member States have joined the third stage of EMU
and therefore have the euro as a single currency.

COUNTRIES ADOPTING THE EUROPEAN CURRENCIES
List of all European currencies
Country Present
currency
Currency
sign
Fractional
unit
Previous currency
Andorra Euro Cent None official
Austria Euro Cent Schilling
Belgium Euro Cent Belgian franc
Cyprus Euro Cent Cypriot pound
Estonia Euro Cent Estonian kroon
Finland Euro Cent Finnish markka
France Euro Cent French franc
Germany Euro Cent Deutsche Mark
Greece Euro Cent Greek drachma
Ireland Euro Cent Irish pound
Italy Euro Cent Italian lira
Latvia Euro Cent Latvian lats
Luxembourg
Euro Cent Luxembourgish franc
Malta Euro Cent Maltese lira
Monaco Euro Cent Monegasque franc
Montenegro
Euro Cent Deutsche Mark
Netherlands
Euro Cent Dutch guilder
Portugal Euro Cent Portuguese escudo
San
Marino
Euro Cent Sammarinese lira
Slovakia Euro Cent Slovak koruna
Slovenia Euro Cent Slovenian tolar
Spain Euro Cent Spanish peseta
Vatican
City
Euro Cent Vatican lira



ADVANTAGE AND DISADVANTAGE OF SINGLE CURRENCY
ADVANTAGES:-
The single currency that we have today can be seen as a logical step in
complementing the Single Market. The benefits of the single currency are:
High degree of price stability
The euro is as stable as the best-performing currencies previously used in the
euro area countries. This has established an environment of price stability in the
euro area, exerting a moderating influence on price and wage-setting. As a
consequence, inflation expectations and inflation risk premia have been kept low
and stable. Even in the more challenging current environment, price stability in the
euro area has not been jeopardised.
More price transparency
Payments can be made with the same money in all countries of the euro area,
making travelling across these countries easier. Price transparency is good for
consumers since the easy comparison of price tags makes it possible for consumers
to buy from the cheapest supplier in the euro area, e.g. cars in different euro area
countries. Therefore, price transparency created by the single currency helps the
Euro system to keep inflation under control. Increased competition makes it more
likely that available resources will be used in the most efficient way, spurring
intra-euro area trade and thereby supporting employment and growth.
Removal of transaction costs
The launch of the euro on 1 January 1999 eliminated foreign exchange
transaction costs and thus made possible considerable savings. Within the euro
area, there are no longer any costs arising from:
buying and selling foreign currencies on the foreign exchange markets;
protecting oneself against adverse exchange rate movements;
cross-border payments in foreign currencies, which entail high fees;
keeping several currency accounts that make account management more
difficult.
No exchange rate fluctuations
With the introduction of the euro, exchange rate fluctuations and therefore
foreign exchange risks within the euro area have also disappeared. In the past,
these exchange rate costs and risks hindered trade and competition across borders.
DI SADVANTAGES:-
One size fits all policy
A single currency requires a single monetary policy. This means interest
rates being set centrally for all Euro countries. Say an individual country is
suffering a downturn in economic activity, but the rest are booming. The
European Central Bank may want to increase interest rates, but that would
simply worsen the recession for that country.

Differing policy effects
Even when countries are closely in line, it may be possible that a single
policy will have different effects on different countries. For example, a much
larger proportion of people own their own house in the UK than many other
European countries. This makes the UK much more reliant on mortgage
lending. A change in interest rates then, may have a different effect on the UK
from other countries.

Shocks
External economic shocks may have an adverse impact. An example
could be a rapid rise in oil prices (as happened in the 1970s and 80s). This may
affect different countries in different ways, depending on how reliant they are
on oil. The UK produces its own North Sea Oil and so may be affected
differently to Luxembourg, which does not!

Transition costs
moving into a single currency economic union involves short term
transition costs (which would disappear once the new currency was fully
established). For example, new money has to be issued and the old withdrawn,
vending machines have to be adapted to take the new coins, and foreign
exchange departments may shrink in size in some financial institutions.

EXCHANGE RATE MECHANISM (ERM II) BETWEEN THE EURO AND
PARTICIPATING NATIONAL CURRENCIES
The Agreement establishes an exchange rate mechanism to replace the old
European Monetary System (EMS), which became obsolete with the introduction
of the euro. The purpose of ERM II is to maintain stable exchange rates between
the euro and the participating national CURRENCIES so as to avoid excessive
exchange rate fluctuations on the internal market. In the interests of clarity and
transparency, the Agreement of 16 March 2006 replaces the previous Agreement
concluded in September 1998 and amended on several occasions for technical
reasons.
ACT:-
Agreement of 16 March 2006 between the European Central Bank (ECB)
and the national central banks (NCBs) of the Member States outside the euro area
laying down the operating procedures for an exchange rate mechanism in stage
three of Economic and Monetary Union (EMU).
Summary:-
The single market must not be endangered by real exchange rate
misalignments or by excessive nominal exchange rate fluctuations between the
euro and the other European Union (EU) currencies, as these would
disrupt TRADE flows between the Member States. This Agreement aims to ensure
a stable economic environment by establishing an exchange rate mechanism
(ERM II) between the euro and the participating national currencies. Participation
in ERM II is optional for the non-euro area Member States, but those Member
States with a derogation can be expected to join. ERM II ensures that participating
Member States orient their policies to stability and convergence, helping them in
their efforts to adopt the euro.
Determining A Central Rate And Intervention Bands:-
A central rate is determined between the euro and each participating non-
euro area CURRENCY, with a standard fluctuation band of 15 % above and below
that rate. All parties to the mutual agreement on the central rates, including the
European Central Bank (ECB), have the right to initiate a confidential procedure to
reconsider the rates.
Decisions are taken by common accord by the ministers of the euro area
Member States, the ECB and the ministers and central bank governors of the non-
euro area Member States participating in the new mechanism, in accordance with a
common procedure involving the Commission and following consultation of
the Economic and Financial Committee.
Under the Agreement, intervention is, in principle, effected in euro and the
participating currencies. The ECB and the NCB or NCBs concerned inform each
other about all foreign exchange intervention. This involves either intervention at
the margins or coordinated intramarginal intervention:
Intervention at the margins. Intervention at the margins is, in principle,
automatic and unlimited. However, the ECB and the participating non-euro area
NCBs may suspend automatic intervention if it conflicts with the primary
objective of maintaining price stability;

Coordinated intramarginal intervention. The ECB and the participating non-
euro area NCBs may agree to carry out coordinated intramarginal intervention.
Prior agreement of the NCB issuing the intervention CURRENCY other
than the euro is obtained when another central bank of the European System of
Central Banks (ESCB) uses the currency concerned in amounts exceeding
mutually agreed limits.
A non-euro area NCB immediately notifies the ECB when it has used the
euro in amounts exceeding the agreed limits.
A bank intending to carry out transactions other than intervention which
involve at least one non-euro area currency or the euro and which exceed agreed
limits must give prior notification to the central bank(s) concerned.
I nterventions: providing very short-term financing:-
For the purpose of intervention in euro and in the participating non-euro area
currencies, the ECB and the NCBs concerned open very short-term credit facilities
for each other. These are for financing intervention at the margins and
intramarginal intervention:
Financing of intervention at the margins. The very short-term financing
facility is in principle automatically available and unlimited in amount for
financing intervention in participating currencies at the margins. The ECB and
the participating non-euro area NCBs may suspend automatic financing if it
conflicts with maintaining price stability;

Financing of intramarginal intervention. The very short-term financing
facility may be made available for intramarginal intervention with the
agreement of the central bank issuing the intervention currency. However, the
amount of such financing must not exceed the ceiling laid down in Annex II to
the Agreement and the debtor central bank must make appropriate use of its
foreign reserve holdings prior to drawing on the facility.
The initial maturity for a very short-term financing operation is three
months. It may be automatically extended once for a maximum of three months,
but the total amount of resulting indebtedness may at no time exceed the debtor
central bank's ceiling as laid down in Annex II. Any debt exceeding that amount
may be renewed for three months subject to the agreement of the creditor central
bank. Any debt already renewed automatically for three months may be renewed a
second time for a further three months subject to the agreement of the creditor
central bank. Operations take the form of spot sales and purchases of participating
currencies, giving rise to corresponding claims and liabilities.
Closer cooperation
At the initiative of a participating non-euro area Member State, exchange
rate policy cooperation may be strengthened. Formally agreed fluctuation bands
narrower than the standard one and backed up in principle by automatic
intervention and financing may be set at the request of the Member State
concerned.
Monitoring the functioning of the system
The General Council of the ECB monitors the functioning of ERM II and
ensures the coordination of monetary and exchange rate policy and the
administration of the intervention and financing mechanisms specified in the
Agreement.
The Agreement provides for closer cooperation between the participating
non-euro area NCBs and the ECB regarding exchange rates. Non-euro area NCBs
not participating in ERM II cooperate with the ECB and the participating non-euro
area NCBs in the consultations and/or other exchanges of information.
Amendments to the Agreement
This Agreement must be amended each time a new national central bank
becomes party to the Agreement on the ERM II. It is also amended each time that a
national central bank ceases to be party to the Agreement, specifically when the
Member State adopts the euro as single CURRENCY.
The Agreement has therefore been amended to take into
account Slovenia, Cyprus and Malta, Slovakia and Estonia joining the euro area,
and also the entry of Romania and Bulgaria into the EU.
INTERNATIONAL MONETARY SYSTEMS AND THE EURO

CURRENT CURRENCY REGI MES:-
The international monetary system in todays international finance arena is
made up of currencies of individual countries, composite currencies, and the newly
emergent single European currency, the Euro. These currencies are linked to one
another on a canvas of different currency regimes. These currency regimes are
classified by the International Monetary Fund (IMF) into eight categories for its
186 member countries. These eight categories span a spectrum with rigidly fixed
and independently floating currencies at its extremities. Four of these eight
categories make up the current currency regimes in 163 member countries (as
indicated in brackets below):
1. Managed floating with no preannounced path for the exchange rate (33)
2. Exchange arrangements with no separate legal tender (39)
3. Other conventional fixed peg arrangements (44)
4. Independent floating (47)
In the first, the monetary authority influences exchange rates through foreign
exchange market intervention without specifying or precommitting to any
preannounced exchange rate path (e.g., Algeria, Singapore, Jamaica, Kenya, and
Norway). In the second, the currency of another country circulates as the sole
legal tender (e.g., dollarization as in Panama since 1907, or more recently in
Ecuador since the beginning of 2000) or the member belongs to a monetary or
currency union where the same legal tender is shared by all members of the union
(e.g., the Euro). In the third regime, the country pegs its currency (formally or de
facto) at a fixed rate to a major currency (e.g., Nepal, Saudi Arabia, and
Turkmenistan) or a basket of currencies (a composite) as in Kuwait, Morocco, and
Vanuatu, where the exchange rate fluctuates within a narrow margin, or at most +
or 1% around a central rate. Finally, under independent floating the exchange
rate is market determined, with foreign exchange market intervention aimed at
stabilizing the exchange rate rather than establishing a level (e.g., India, Japan,
New Zealand, Switzerland, and the USA).
The remaining minor four categories of the eight categories classified by the
IMF are crawling pegs (4), exchange rates within crawling pegs (5), pegged
exchange rates within horizontal bands (6), and currency board arrangements (8).
In the case of the first two, either the currency is adjusted periodically in small
amounts or maintained within certain fluctuation margins around a central rate that
is adjusted periodically at a fixed, preannounced rate or in response to changes in
selective quantitative indicators. Pegged exchange rates within horizontal bands
allow the value of the currency to be maintained within margins of fluctuation
around a formal or de facto fixed peg that are wider than + or 1% around a
central rate. Finally, currency board arrangements represent a monetary regime
based on an implicit legislative commitment to exchange domestic currency for a
specified foreign currency at a fixed exchange rate, combined with restrictions on
the issuing authority to ensure the fulfillment of its legal obligation.

Currency regimes and currency crises:
As globalization increases, the decade of the nineties has seen a progressive
sequence of currency crises in emerging markets: the Mexican crisis [1994-95], the
Asian crisis [1997], the Russian crisis [1998], the Brazilian crisis [1998-99], and
finally the Argentinian crisis [2002]. Most of the policymakers responses to these
crises were based on an increase in the IMFs funding to bail out these economies.
However, this bail out has often resulted in fueling these crises by creating a moral
hazard in lending behavior. Failure of these economies to deliver on promised
fiscal reforms also illustrates the low credibility of the conditionality the IMF
imposes.
Some of the alternatives suggested for avoiding such currency crises follow:
i) Currency controls: As Tobin suggested many years ago, other economists have
advocated abandoning free capital movement by imposing some controls to
insulate a nations currency from speculative attacks [e.g., Malaysia]. While
this may work over limited periods of time, for the long-term most developing
countries benefit from foreign capital, and the know-how, discipline, and more
efficient resource allocation that go with such capital flows.

ii) Freely floating currency: Milton Friedman noted that with a freely floating
currency, there has never been a currency crisis. This is because the floating
rate absorbs the pressure built up in countries that try fixing the exchange rate
while pursuing an independent monetary policy. It is often argued that the
Asian crisis did not spill over into Australia and New Zealand because they had
floating exchange rates. Increased capital mobility pressures due to
globalization have driven some countries [e.g., Turkey in early 2002] to a free-
floating exchange rate.

iii) Fixed exchange rate: There are three possible ways devised to fix an exchange
rate in todays floating exchange rate environment [characterized by just 80 out
of the 186 IMF member countries] currency board, dollarization, or a
monetary union. In all three cases, the fixed exchange rate system is made
viable by surrendering monetary independence to a foreign / single central
bank: the Federal Reserve for countries that dollarize, as well as countries such
as Argentina and Hong Kong that have dollar-based currency boards [as the de
facto central bank], and the European Central Bank for countries using the
Euro. Increased capital mobility pressures due to globalization have driven
some countries [e.g., Argentina with a currency board (1991 2001) and
Ecuador with dollarization in early 2002] to a fixed rate regime. Monetary
union is best exemplified by the Euro countries.
An ideal currency would be characterized by three attributes: a fixed
value (exchange rate stability), convertibility (full financial integration), and an
independent monetary policy (monetary independence). Using any of the
alternatives for avoiding currency crises suggested in the earlier paragraphs,
entails sacrificing one of these three attributes. This is why Jeffrey Frankel
refers to the three attributes of an ideal currency as the Impossible Trinity
[Source: The international financial architecture, Jeffrey A. Frankel,
Brookings Policy Brief #51, June 1999].

EMS AND MONETARY UNI ON:-
The European Monetary System (EMS) originally proposed by the German
Chancellor Helmut Schmidt, was formally launched in March 1979. The main
goals of the EMS were:
i) Establishing a zone of monetary stability in Europe
ii) Coordinating exchange rate policies vis--vis the non-EMS currencies.
iii) Paving the way for the European Monetary Union.

Brief background: The Smithsonian Agreement was signed in December 1971,
towards the end of the Bretton Woods era of pegged exchange rates [as against the
fixed exchange rate alternatives discussed above], to expand the band of exchange
rate movements from the original plus or minus 1 percent to plus or minus 2.25
percent. However, members of the European Economic Community (EEC)
decided on a narrower band of plus or minus 1.125 percent for their currencies.
This scaled-down, European version of the declining, Bretton Woods pegged
exchange rate system was dubbed the snake, derived from the way EEC
currencies moved together closely within the wider band permitted by the
Smithsonian Agreement for other currencies like the US dollar. The EEC
countries adopted the snake in the belief that stable exchange rates among the
EEC countries were essential for promoting intra-EEC trade and ultimate
economic integration. The snake system was replaced by the EMS in 1979.
Note: In a fixed rate system, there is loss of monetary independence. This loss of
monetary independence is the fundamental difference between a truly fixed-rate
system and a pegged rate system like Bretton Woods. In a fixed rate system, the
money supply adjusts to the balance of payments. If there is a balance of payments
deficit, the supply of currency falls; with a surplus, it rises. With a pegged-rate
system, governments can temporarily avoid allowing their money supply to adjust
to a balance-of-payments deficit by borrowing from abroad or reducing their
foreign exchange reserves to maintain the pegged rate. The pegged rate system
calls for monetary and fiscal coordination. With persistent deficit fueled by
excessive growth of the money supply, such coordination is extremely difficult to
sustain. No wonder the Bretton Woods system, inspite of the Smithsonian
Agreement, collapsed.
The two main instruments of the EMS were the European Currency Unit
(ECU) and the Exchange Rate Mechanism (ERM):
1. The ECU is a composite currency (or basket currency) constructed as a
weighted average of the currencies of member countries of the European Union
(EU). The weights were based on each currencys relative GNP and share in
intra-EU trade. The ECU served as the accounting unit of the EMS and was an
essential component of the ERM.
2. The ERM refers to the process adopted by the EMS member countries to
manage their exchange rates. The ERM was based on a parity grid system,
which was a system of par values among ERM currencies. The par values in
the parity grid were computed by defining the par values of each of the EMS
currencies in terms of the ECU. These par values were called ECU central
rates. The entire parity grid could be computed by referring to the ECU central
rates set by the European Commission.

To enable the European Monetary Union (EMU), the member countries
agreed to closely coordinate their fiscal, monetary, and exchange rate policies and
achieve a convergence of their economies. Specifically, each member country
agreed to keep the ratio of government budget deficits to gross domestic product
(GDP) below 3 percent, keep gross public debts below 60 percent of GDP,
maintain long-term interest rates at no more than 2% above the average for the
three members with the lowest interest rates, achieve a high degree of price
stability, and maintain its currency within the prescribed ranges of the ERM.
The EMU is a single currency area, informally also known as the Euro zone,
within the European Common Market in which people, goods, services, and capital
are supposed to move without restrictions. Beginning with the Treaty of Rome in
1957, continuing with the Single European Act of 1987, then the Maastricht Treaty
of 1991-92, and the Treaty of Amsterdam in 1997, a core set of European countries
have worked steadily toward integrating themselves into one larger, more efficient,
domestic market. Even then, the use of different currencies required that
consumers and corporations treat the individual markets separately. Currency risk
of cross-border commerce still persisted. The creation of a single currency is
designed to move beyond these vestiges of separated markets.

EURO AND OPTI MAL CURRENCY ZONES:-
The 15 members of the European Union are also members of the EMS. This
group has tried to form an island of fixed exchange rates in a sea of major floating
currencies. Since the EMS members have significant trade with each other, they
perceive significant benefits in their daily interaction with each other with fixed
exchange rates.
Introduction of the Euro into the international financial markets helps these
member countries in at least three different ways:
i) countries in the Euro zone enjoy lower transaction costs;
ii) currency risks and costs related to exchange rate uncertainty are reduced;
iii) all consumers and businesses both inside and outside the Euro zone enjoy price
transparency and increased price-based competition.

Member EMS countries that have not joined the Euro yet, have been
weighing the pros and cons of doing so.The UK feels the Euro will increasingly
infringe on its sovereignty and has so far decided not to participate. Sweden does
not see significant benefits from EU membership as one of its newest members and
so has not joined. Denmark, like the UK and Sweden, has a strong political
element which is highly nationalistic, and has also stayed away.
Monetary policy for the EMU is conducted by the European Central Bank
(ECB), which has the major responsibility of safeguarding the stability of the Euro.
Stability is achieved by protecting the currencys purchasing power which can
quickly erode with inflation. The ECB, which has been modeled after the Federal
Reserve System in the US or the Bundesbank in Germany, will target inflation so
as to reduce the probability of undermining the Euro.
The idea of optimum currency areas emerges from the trade-off between the
gains and losses implicit in too large or too small unit currency areas. In other
words, such an optimum currency area trades off the lower transaction costs
associated with a single currency against its greater vulnerability to economic
shocks. It is difficult to assess how large or small such an optimum currency area
should be. Some economists argue that Europe would be better with four or five
different regional currencies than only one. Similarly, some others have argued
that the US too might do better with several regional currencies to cushion shocks
such as the ones in the Midwest and the Southwest during the 1980s and the
Northeast and California in the 1990s.
However, the experience with floating exchange rates since the 1970s will
encourage second thoughts among the proponents of that system. On the other
hand, economic flexibility, especially of labor markets is critical to costs associated
with currency union. Such flexibility can be attained through further deregulation,
privatization, freer trade, labor market and social welfare reform, as well as a
reduction in economic controls, state subsidies, and business regulations. If these
changes do not occur in a sizable single currency area such as the Euro zone or the
US for that matter, monetary union will intensify economic shocks because their
effects can no longer be mitigated by exchange rate adjustments.
Economic flexibility in labor markets is essential, else, monetary union can
impose high costs when wages and prices are inflexible. Take the case of global
demand for French goods: if it falls sharply, French goods must be made cheaper
and new, efficient industries must replace old, inefficient industries. One way out
is to reduce wages which cannot be done quickly. Eventually, higher
unemployment forces lower wages, but the social and economic costs of the
process are high. In contrast to lowering wages by 10%, a depreciation of the
French franc by 10% would have achieved the change quickly and effortlessly.
On the other hand, if the demand for French goods rises sharply, it would
lead to inflation unless the French franc is allowed to appreciate. That is, currency
changes can substitute for periodic phases of inflation and deflation as illustrated
by these demand changes in the upward or downward direction, respectively. Now
that France has entered the Euro zone, it no longer has the option of changing its
exchange rate to face such demand shocks effectively.

The Future: Rules vs Discretion and Independence vs Cooperation
Rules vs Discretion reflect a country governments attitude vis--vis foreign
exchange market intervention. Does the government have strict intervention
requirements, i.e., Rules, or does it choose whether, when, and to what degree to
intervene in the foreign exchange markets, i.e., Discretion.
Independence vs Cooperation reflects the tradeoff for countries participating
in a specific system: operating as part of a system, but acting on their own, i.e.,
Independence, or consulting and acting in unison with other countries, i.e.,
Cooperation. The present international monetary system is characterized by no
rules, with varying degrees of cooperation.

Looking back at a century of international monetary systems
chronologically, regime structures like the gold standard required no cooperative
policies among countries, only the assurance that all countries would abide by the
rules of the game. In the gold standard in effect prior to World War II, this was
interpreted as the willingness of governments to buy or sell gold at parity rates on
demand. The Bretton Woods agreement (1944 1973) required more cooperation
in that gold was no longer the rule, and countries were required to cooperate to a
higher degree to maintain the dollar-based system. The European Monetary
Systems fixed exchange rate band system (1979 1999) was a hybrid of such
cooperative and rule regimes. While there is no consensus on what the
international monetary system of the future should look like, many believe that it
could succeed only if it combined cooperation among nations with individual
discretion to pursue domestic social, economic, and financial goals.