THE EUROPEAN MONETARY SYSTEM AND THE EURO The optimum currency area literature suggests that in a regional setting

THE EUROPEAN MONETARY SYSTEM AND THE EURO The optimum currency area literature suggests that in a regional setting

like Western Europe a system of fixed exchange rates might be appro- priate. While the establishment of the common euro currency may be viewed as a kind of permanently fixed exchange rate, prior to the euro, a system to link currencies and limit exchange rate flexibility had been in place since the late 1970s. The European Monetary System (EMS) was established in March 1979. The EMS committed the mem- ber countries to maintaining small exchange rate fluctuations among themselves, while allowing for large fluctuations against outside curren- cies. The EMS worked quite well through the 1980s and led to opti- mism that the member nations eventually could evolve into a system with one European central bank and one money. It was in this spirit that the Maastricht Treaty was signed in December 1991 and a timetable for the evolution of the system was spelled out. The treaty called for: • The immediate removal of restrictions on European flows of capital

and greater coordination of monetary and fiscal policy. • The establishment of a European Monetary Institute (EMI) in January 1994 to coordinate monetary policies of the individual central banks and make technical preparations for a single monetary policy.

• The irrevocable fixing of exchange rates among all member countries, with a common currency and a European Central Bank in January 1997, at the earliest, and by January 1999, at the latest. This last step did not occur until January 1999. The countries that

moved to this last step of monetary union required their macroeconomic

50 International Money and Finance

not exceed 3 percent of GDP, and outstanding government debt did not exceed 60 percent of GDP.

The new European currency, the euro, made its debut on January 1,1999. The symbol is h, and the ISO code is EUR. Euro notes and coins began to circulate on January 1, 2002. In the transition years of 1999 to 2001, people used the euro as a unit of account, denominating financial asset values and transactions in euro amounts. Bank accounts were available in euros and credit transactions were denominated in euros. However, actual cash transactions were not made with euros until euro cash started circulating in 2002.

Prior to the beginning of the euro, the value of each of the “legacy cur- rencies” of the euro-area countries was fixed in terms of the euro. Table 2.5 shows the exchange rates at which each of the old currencies was fixed in terms of the euro. For instance, 1 euro is equal to 40.3399 Belgian francs or 1.95583 German marks. Of course, the prior monies of each of the Eurozone countries no longer are used, having been replaced by the euro.

One money requires one central bank, and the euro is no exception. The European Central Bank (ECB) began operations on June 1, 1998, in Frankfurt, Germany, and now conducts monetary policy for the Eurozone countries. The national central banks like the Bank of Italy or the German Bundesbank are still operating and perform many of the functions they had prior to the ECB, such as regulating and supervising banks and facilitating payments systems in each nation. In some sense they are like the regional banks of the Federal Reserve System in the

Table 2.5 Exchange Rates of Old National Currencies Replaced by the Euro Former currency

1 euro

Belgian franc BEF40.3399 German mark

DEM1.95583 Spanish peseta

ESP166.386 Finnish markka

FIM5.94753 French franc

FRF6.55957

International Monetary Arrangements 51

United States. Monetary policy for the euro-area countries is conducted by the ECB in Frankfurt just as monetary policy for the United States is conducted by the Federal Reserve in Washington, D.C. Yet the national central banks of the euro-area play an important role in each of the respective countries. The entire network of national central banks and the ECB are called the European System of Central Banks. Monetary policy for the euro-area is determined by the Governing Council of the ECB. This council is comprised of the heads of the national central banks of the euro-area countries plus the members of the ECB Executive Board. The board is made up of the ECB president and vice-president and four others chosen by the heads of the governments of the euro-area nations.

Recently several new member countries have been added. EU members that have been added since the first 12 countries are: Cyprus, Estonia, Malta, Slovakia and Slovenia. That makes it 17 out of the 27 EU members that are part of the Eurozone as of March, 2011. In addition, small countries that are not part of the EU have unilaterally adopted the euro, for example, Monaco, San Marino and the Vatican. In contrast, three member countries of the European Union that are eligible have not adopted the euro and still main- tain their own currencies and monetary policies. These three countries are Denmark, Sweden, and the United Kingdom. It remains to be seen when, and if, these countries become part of the Eurozone.