It was an arrangement/mechanism by which the exchange rate between the member countries in the European Union can be stabilized and inflation rate between the countries can be reduced. The working of the system is made possible by the interaction of three elements, which are given below (The European Monetary System)
Currency stability had been a concern among major countries since the Second World War and finally found a solution through a system of a fixed exchange rate, called Bretton Wood System. Bretton Wood System was collapsed in early 1970, but European leaders were keen to stabilize the exchange rate as opposed to another system called floating rate of return. 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 EMS was stressed by the conflicting economic policies and conditions of its members, especially the newly reunified Germany, and Britain permanently withdrew from the EMS
In 1994 the European Monetary Institute was constituted as a transitional step in establishing the European Central Bank (ECB) and a common currency. The ECB, which was established in 1998, 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.
On January 1, 1999 when the Euro was first launched in electronic form, it replaced the European Currency Unit (ECU) made up of defined quantities of twelve EU members at the rate of ‘one ECU equal to one Euro’, as of January 1, 1999. The national currency units of member states were automatically re-denominated to Euro on December 31, 2001.
The working of EMS
The main responsibility of EMS is to keep the exchange rate of a member country’s currencies within bands. In fact, the very aim of creating the EMS was the stabilization of the exchange rates of the participating countries by means of the Exchange Rate Mechanism (ERM). A maximum limit of 2.25 percentages was allowed for countries to fluctuate the exchange rate (European Monetary System, 2007)
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 realized with the launching of the Euro in 1999". .