Lessons from the European Monetary System

Many economists and policy makers have argued that the industrialized countries could minimize exchange-rate volatility and enhance economic stability if West Germany, Japan, and the United States linked their currencies in a target zone arrangement.

Under a target-zone system, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. Such a system already exists for the major European currencies in the form of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS). A review of the ERM provides valuable lessons about the operations, costs, and benefits of target-zone arrangements.