European Monetary Union

The European Monetary Union (EMU) represents countries within the European Union that have agreed to have a common currency, the euro, and a common monetary policy. As of July 2008, 15 of the 27 countries that form the European Union were part of the EMU.

The EMU is the culmination of the process that began in 1971. Just before what was to be the advent of the floating exchange rate regime in 1973 after the collapse of the Smithsonian agreement of 1971, European Common Market (later to be known as European Union) countries had agreed to stabilize the values of their currencies against each other within a narrow band. A new set of parities had been agreed to in 1971, but the central banks were still responsible for maintaining the exchange rates of their currencies within bands of ± 2.25 percent agreed at the Smithsonian Institution.

In 1972 Common Market countries agreed to maintain parities of their currencies within a narrower band of ± 1.25 percent (called a snake) than the band within which the same currencies could float against the dollar (called a tunnel) set by the Smithsonian agreement. The system came to be known for a while as the “snake within the tunnel.” After the collapse of the Smithsonian agreement in 1973, it was agreed that the “snake” would be retained but the “tunnel” would be abandoned. Other industrialized countries had by that time adopted the fluctuating exchange rate system in which the markets determined the values of the currencies.

The turbulence that followed the advent of the floating rate regime proved incompatible with the goal of promoting intra-union trade and integration of the Common Market economies. To counter the effects of the volatility of exchange rates, a European Monetary System was established in March 1979. The centerpieces of this system were (1) the Exchange Rate Mechanism that limited the exchange rate movements between the currencies of the member countries to within ±2.25 percent (± 6 percent for Italian lira) of the established parity rates, and (2) a basket currency called European Currency Unit (ECU). The exchange rates were to be maintained within their defined bands through a European Monetary Cooperation Fund. One of the unique aspects of this Exchange Rate Mechanism was that when an exchange rate between two currencies moved close to one of the limits defined by the 2.25 percent bands, both the countries whose currencies constituted that exchange rate were required to intervene in the foreign exchange market. The usual practice in the international financial markets had been that the country whose currency depreciated with respect to others was required to intervene and protect the value of the currency.

The Cooperation Fund was also used to coordinate the monetary policies of member countries. The basket currency ECU was an artificial concept that consisted of fixed amounts of national currencies. There were nine national currencies in the basket in 1979 and 12 by 1989 (addition of more currencies was barred by the Maastricht Treaty). ECU was to be used only for settling accounts between countries and in financial markets. Actual notes and bills denominated in ECU were never issued, although individuals could open bank accounts denominated in ECUs. Over time, the currency became a popular unit for issuance of financial instruments such as bonds.

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