European Monetary Union Essay

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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.

The foundations  of the European Monetary Union were  laid in  December  1991 when  the  Maastricht Treaty was put forward for approval by member countries.  In spite of the currency crisis of 1992–93, and initial rejections by voters in some countries, the treaty was adopted in November 1992.

The essence of the treaty was the formation  of a monetary  union and adoption  of one currency. The common currency would be issued by the European Central  Bank (ECB) and  ECB would  conduct  the monetary  policy for the  countries  using the  common currency. These countries  would give up their control  over the monetary  policy in their economy. Countries’ existing central banks would become instruments of ECB.

Following the recommendations of the original report,  countries  were allowed to join the monetary union if they met all four of the following convergence criteria—known  as Maastricht  criteria—established in 1998. Countries  have the option of “opting out” of the union.

  1. Fiscal deficits: The government deficit must not exceed 3 percent of the country’s gross domestic product and the total government  debt must not  exceed  60  percent   of  the  gross  domestic  product—declining  debt  level is, however, acceptable.
  2. Price stability: The inflation rate of the country over the previous year must not exceed by more than one and a half percentage points the average inflation rates  of the  three  member  states with the lowest inflation rates.
  3. Interest rates: The long-term nominal  interest rate must not exceed by more than two percentage points the average of the long-term  interest rates of the three member states with the lowest interest rates.
  4. Exchange rate: The exchange rate of the country must have remained within the fluctuation margins (± 15 percent since the 1992–93 exchange rate crises) provided  for by the  exchange-rate mechanism and must not have faced severe tensions for at least the last two years before entry.

In addition, it is required  that there be legal compatibility for the central  bank to join the monetary union in the form of freedom from political interference. The treaty  also requires  compatibility  on factors like balance of payments, integration  of markets, and unit labor cost without setting specific numerical goals. These criteria are not applied very rigidly—the final decision as to whether a country will be allowed to join or not is political.

The   European   Monetary   Union   was   formally launched  on January 1, 1999, with 11 countries  (Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal, and Finland). Euro was the name chosen for the common  currency and its value was fixed in terms of the national currencies. Greece joined two years later. Three other countries have since joined the EMU (Cyprus, Malta, and Slovenia). Other  countries  (Bulgaria, Czech Republic, Denmark, Estonia, Latvia, Lithuania, Hungary, Poland, Romania, Slovakia, Sweden, and the United Kingdom) are members of the EU but do not use the euro as their currency. Of these, Denmark and the United Kingdom have decided  to  “opt out” from  participation,  while the remainder  (many of the newest EU members plus Sweden) have yet to meet the “convergence criteria” for adopting the single currency.

For the first three years, the euro was used simultaneously  with the  national  currencies  for financial statements and public accounts. Bank notes and coins were introduced on January 1, 2002, and by July 1 of that year old national currencies were no longer legal tender in their countries.


The European Monetary Union has not been an unqualified  success. It has improved  economic  efficiency because introduction of one currency has eliminated    risks   associated   with   exchange   rate changes within the euro area as well as transaction costs associated with conversions of currencies. After an initial bout of inflation resulting from the tendency of retailers to take advantage of conversion of prices from national currencies into euro, prices in member countries have shown a tendency to convergence. Use of one currency has encouraged development of integrated  financial markets.  Early in 2008, the volume of bonds  denominated in euros  exceed that  of dollar bonds for the first time ever. The share of euro in international reserves held by countries has increased over the past decade.

On the down side, countries are feeling the effects of loss of independence of monetary policy. When the euro rises in value against other currencies, as it has done  since 2002, member  countries  feel the  effects differently. Lacking ability to implement  different monetary policies in the absence of full factor mobility may lead to loss of a country’s international competitiveness. This is indeed the case for Greece, Spain, Italy, and Portugal in 2008.

Introduction of a common currency in Europe has been one of the landmark events in European history. There is very strong will in large parts of Europe for this experiment to succeed. Chances are the euro will be around for a while.


  1. European Commission,  EMU @ 10: Successes and Challenges after Ten Years of Economic and Monetary Union, European  Economy, 2008, No. 2 (Office for Official Publications of the European Communities,  2008);
  2. European Commission,  One  Currency  for One  Europe: The Road to the Euro (Office for Official Publications  of the European  Communities,  2007);
  3. R. Lane, “The Real Effects of European Monetary Union,” Journal of Economic Perspectives (v.20/4, 2006);
  4. Anna Lipińska, “The Maastricht Convergence Criteria and Optimal Monetary Policy for the EMU Accession Countries,” Working Paper No. 896 (European Central Bank, 2008);
  5. P. Mongelli, “What Is European Economic and Monetary Union Telling Us About the Properties of Optimum Currency Areas?” Journal of Common Market Studies (v.43/3, 2005);
  6. Hanspeter Scheller, The European Central Bank—History, Role and Functions, 2nd  ed.  (European  Central  Bank,  2006);
  7. Emil Stavrev, “Growth and Inflation Dispersions in EMU: Reasons, the Role of Adjustment  Channels,  and  Policy Implications,” IMF Working Paper, WP/07/167  (International Monetary Fund, 2007);
  8. Malcolm Townsend, The Euro and Economic and Monetary Union: An Historical, Institutional and Economic Description (John Harper, 2007);
  9. Wyplosz, “European Monetary Union: the Dark Sides of a Major Success,” Economic Policy (v.21/46, 2006).

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