European Monetary Union

Again there were varying degrees of intervention but the United Kingdom did not formally peg sterling until it joined ERM in 1990 after shadowing the Deutsche mark in 1988 and 1989. The United Kingdom subsequently left the ERM in 1992 to float once more.

The Exchange Rate Mechanism is part of a plan for European Monetary System (EMS). The EMS was created with the idea that it might restore the stability of exchange rates in Europe. The EMS consists of three elements--the Exchange Rate Mechanism (ERM), the European Currency Unit (ECU) and the European Monetary Fund (EMF). These three elements were originally designed to work together to achieve monetary integration among the European Community member states. The ERM and ECU are the vehicles through which the central exchange rates of member countries were to be set and kept at parity. The EMF, which has not yet been established, is to ultimately replace the International Monetary Fund for the European Community countries. The hope in calling for the creation of EMF was that it would eventually operate as the central bank for the European Community with the power to create new international reserves (Canto, 1991).

The ECU is a weighted basket of all European Community (EC) currencies. The weight of each currency is determined in proportion to the economic strength of each country.

The ruling conservative party in Britain is now deeply split over the single currency issue as well as monetary union. A year after the collapse of the ERM, John Major argued that economic and monetary union was not feasible under present circumstances (Franklin, 1993). Within the conservative cabinet only Kenneth Clarke, the finance minister, has stated publicly that he favors monetary union while much of the British financial community and even British farmers are now voicing increasing doubts about the entire process (Aitken, 1996).

Essentially two instruments were available to the British to keep their currency within these margins: interest rate policies and direct interventions on the foreign exchange market. Under normal conditions, for example, when the pound approached the lower margin of its Deutsche mark band, the Bank of England could sell foreign currency or it might raise short-term interest rates to prevent the pound from depreciating further. To finance such an intervention it might either draw on its own reserves or borrow from other sources (international capital markets or central banks). In the ERM, access to foreign exchange reserves is facilitated by the Very Short-Term Financing Facility (VSTF). Under the VSTF, the Bank of England was allowed to borrow marks from the Bundesbank virtually without limits, with the Bundesbank being obliged to grant such credits upon request (Canto, 1991).

In addition to the narrow margins of fluctuation a "maximum divergence spread" was also established. This divergence limit was set at 75 percent of the allowable margin of fluctuation for cash currency. When a country reached its "maximum divergence spread" it was required to take appropriate action to move its currency closer to the central rate.

Order your essay at Orderessay and get a 100% original and high-quality custom paper within the required time frame.