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International Finance

Third edition

by Keith Pilbeam

Chapter 16 - The European Monetary System and European Monetary Union

In this chapter, we examine one of the most important economic issues ever tackled by the European Union (EU), namely Economic and Monetary Union (EMU). On 1 January 2002 EMU was finally realized in Europe when 11 founding countries agreed to irrevocably fix their exchange rates with no margin of fluctuation and agreed to replace their national currencies with a new European currency called the euro. As we shall see, as well as agreeing to give up their monetary sovereignty, they also agreed to certain rules which have limited to some extent their freedom with respect to fiscal policy in the form of the 1996 Stability and Growth Pact. Despite its realization, the issue of EMU in Europe still has a great deal of relevance since the United Kingdom, Denmark and Sweden have still not joined. In addition, the European Union was enlarged with 10 new members on 1 May 2004, many of them former Eastern-bloc countries committed in principle to replacing their national currencies with the euro at some point in the future. When joining the EMU countries currently have to accept certain fiscal restraints as outlined in the Stability and Growth Pact and there has been much recent debate about how to reform this pact. Finally, the impact of the monetary union on trade and financial markets and institutions is still very much being felt, and the performance of the European Central Bank and the euro in the foreign exchange markets is closely monitored by financial market participants.

In this chapter, we review the history behind EMU and we spend some time looking at the features and operation of its predecessor, the European Monetary System, which commenced operations in March 1979 and ultimately proved to be the vehicle for achievement of EMU. We describe the EMS and evaluate its performance during its years of operation, including an analysis of the major crises that confronted the system in 1992/93 and the convergence process in the run-up to EMU. We then proceed to look at the economic gains/losses to be expected from EMU including some recent controversial empirical research on the topic. We review the various safeguards that have been put into place to ensure that the euro will be a sound lowinflation currency, with particular focus on the Stability and Growth Pact, and then proceed to look at the arrangements for the management of the euro under the socalled EuroSystem. Finally, we look at some of the issues raised by potential new entrants into the EMU distinguishing between the cases of the United Kingdom and the Accession countries which joined the European Union in 2004.