European Monetary System: Europe’s Bretton Woods System

The first stirs of a common European currency came in Europe with the creation in 1978 of a currency bloc known as the European Monetary System (or EMS). A group of European countries, primarily Germany and France, designed this system along the lines of the Bretton Woods to keeping their exchange rates within prescribed and narrow bands. These bands might be periodically realigned, but in between realignments each nation would ensure that member-country exchange rates remain inside the band.

One implication of a fixed-exchange-rate  as we explained earlier in this chapter, is that countries must give up control over domestic interest rates. If France has an exchange rate that is tight~y-tied to Germany, free-market French interest rates cannot diverge significantly from those in Germany. A major divergence would lead to an avalanche of financial flows that would either overturn the exchange-rate system or drive interest rates together.

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