Question

What is a target zone? What is the historical importance of the European Monetary System (EMS)?

*Please type and answer in detail*

Answer 1

1. Target Zones- Target Zones are Implicit boundaries on exchange rates established by central banks. Under a managed float, the ideal range of exchange rates of a currency that a government seeks to maintain. The target zone may encourage a weak currency regime in order to encourage exports or a strong currency to reduce inflationary pressures. The Central Bank or other relevant body intervenes in the forex market with some frequency in order to keep the exchange rate within the target zone.

2. European Monetary System- The European Monetary System (EMS) is a 1979 arrangement between several European countries which links their currencies in an attempt to stabilize the exchange rate. The European Economic and Monetary Union (EMU), an institution of the European Union (EU), which established a common currency called the euro replaced the EMS.

Below are the Historical Importance of the EMS:

1. The European Monetary System (EMS) was founded in 1979 after the collapse of the 1972 Bretton Woods Agreement, meant to help foster economic and political unity in Europe and pave the way for a future common currency, the euro.

2. The EMS established a new policy of linked currencies between most countries in the European Economic Community (EEC) to stabilize foreign exchange and prevent large fluctuations in inflation among member countries.

3.  Another important tenet of the EMS was the formation of the European Currency Unit(ECU), a prelude to the euro. The ECU determined exchange rates among the participating countries’ currencies via officially sanctioned accounting methods.

4. The early years of the EMS were marked by uneven currency values and adjustments that raised the value of stronger currencies and lowered those of weaker ones. However, after 1986, changes in national interest rates were specifically used to keep all the currencies stable.

5. The EU created the European Monetary Institute to transition to the European Central Bank (ECB), which came into being in 1998. The primary responsibility of the ECB was to institute a single monetary policy and interest rate working with national central banks including the common euro currency. ECB is responsible for controlling inflation; however, unlike most central banks it was not charged with boosting employment rates or functioning as a lender to governments during financial difficulty.