ility 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. Since Germany is by far the strongest EC nation the Deutsche mark is often referred to as the anchor of the ECU. Initially, each EC currency was allowed to fluctuate within a margin of 2.25 percent around the central rate. Some early exceptions to this general rule were Italy and Spain which were each allowed a larger margin of plus or minus 6 percent (Deravi, 1988).
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. This method of intervention would become known as the Exchange Rate Mechanism (ERM). The ERM was actually a form of intervention designed to bring a currency back into alignment when it threatened to move outside of its maximum band (Barrell, 1990).
When the EMS started operati...