At their meeting in Brussels last December, the heads of government or state of EEC member countries agreed to establish a new European Monetary System (EMS). The entry into force of the system was delayed, however, until 13th March because the French Government were not willing to allow it to come into operation until certain questions affecting agricultural prices in the Community had been resolved.
One of the main elements of the EMS is an exchange rate and foreign exchange market intervention mechanism between the currencies of EEC countries. The United Kingdom, whilst participating in the EMS viewed as a whole, decided not to take part in these exchange arrangements at their outset. Nevertheless, the arrangements have been the subject of considerable public interest, and this article therefore sets out to provide a technical explanation of them and more particularly of the rules for determining when central banks should intervene to defend their exchange rates.
There are two separate but overlapping components which make up the exchange rate and foreign exchange market intervention mechanism. One, which has been called the 'parity grid', is essentially the system which was operated from 1972 by the countries participating in the European 'snake'. The other mechanism is new, and aims to assist greater convergence of members' economies by identifying when one participating currency is beginning to diverge from the average performance of all member countries' currencies, so that early action can be taken. For this purpose a 'divergence indicator' has been instituted.