"A crucial element for the stability of the EMS is the perception on the part of the financial markets that the authorities are strongly committed to defending their exchange rates" Discuss.

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"A crucial element for the stability of the EMS is the perception on the part of the financial markets that the authorities are strongly committed to defending their exchange rates". Discuss this statement with reference to the roles that speculators and German reunification had in the EMS crisis of 1992/93. How did the crisis influence the future path of monetary integration?

A fixed exchange rate regime operated in Europe in the post war period until the early 1970s. The European Monetary System replaced Bretton Woods; it begun in 1979 and ended on 31 December 1998, with the launch of the Euro. The EMS was an example of an 'incomplete' monetary union, and it had two principal components - the Ecu, and the Exchange Rate Mechanism (ERM).

The ERM was a predecessor to the Euro, but the first direction towards a common currency in Europe was the 1957 Treaty of Rome. Although its aim was a common market - not a monetary union - the Treaty did aspire towards the liberalisation of capital flows (which is a feature of a complete monetary union). But the defining event was the Werner Report of 1970, delivered by the Luxembourg Prime Minister. This Report was the first attempt to talk about monetary union, and concluded that it could be a reality by 1980. Although this date was missed by almost 20 years, the Report had no rigid timetable. The 3 stages set out were I) the voluntary reductions of fluctuation margins between the currencies of Member States 11) total liberalisation of the flow of capital, and iii) the irrevocable fixing of the exchange rates between different currencies.

The 1971 Smithsonian Agreement was an attempt to salvage Bretton Woods; each currency was allowed to fluctuate 2.25% either side of the existing $US exchange boundaries - giving EC currencies an effective margin of 9% - at the time, such a boundary was ineffective. An attempt to preserve a certain order in inter-European exchange movements was the 1972 Snake in the Tunnel - this narrowed intra-EC margins to 4.5%. This also enforced rules for joint intervention when a currency reached its band limit.
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The Ecu was a basket of EC (EU) currencies, and could be used as a unit of account for all EU transactions. Each currency's weighting in the Ecu was reviewed at 5-year intervals. Traditionally, the German Deutschmark (DM) had the largest weighting, followed by the French Franc (Ffr) then UK Sterling.

However, more critical to European monetary stability was the ERM. Like Bretton Woods, the ERM was an 'adjustable peg' system. Each currency was pegged at a central rate against the Deutschmark (DM), around which it could fluctuate freely so long as it remained within bands of ...

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