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How Economic and Monetary Union works

Economic and Monetary Union is not an end in itself. It is an instrument to further the objectives of the European Union and improve the lives of citizens in the Member States.

The operations and management of EMU are designed to support sustainable economic growth and high employment through appropriate economic and monetary policy-making. This involves four main economic activities:

  • Implementing an effective monetary policy for the euro area with the objective of price stability
  • Coordinating economic and fiscal policies in Member States
  • Ensuring the smooth operation of the single market
  • Supervising and monitoring financial Institutions

Why are these activities important?

Monetary policy involves influencing interest rates and exchange rates to benefit a country’s economy. This is achieved through a central bank controlling the supply of money in the economy. However, if each EU Member State operated its own monetary policy, then the single market would be much less effective, trade could be disrupted and the benefits would be fewer.

For this reason, under EMU, monetary policy is closely coordinated, and within the euro area it is centralised and independent.

Member State governments control other economic policy areas. These include fiscal policy that concerns government budgets, tax policies that determine how income is raised, and structural policies that determine pension systems, labour- and capital-market regulations. However, EMU brings more economic integration, and the euro area even more so. As a consequence, economic policy-making becomes a matter of common concern to all Member States. To ensure the smooth operation of the EU economy as a whole, it is important that Member States coordinate their economic and fiscal policies with the common objective of stability and growth.

As well as bringing the benefits of economic stability, EMU and the single currency also support a more effective single market which benefits citizens and enterprises. If national economic policies act to discourage the free movement of goods, services, capital and labour, then these benefits, including jobs and growth, would be reduced. Therefore, economic policy-making in the Member States should act to support the single market.

A single banking system is the mirror image of a single money. As the vast majority of money is bank deposits, money can only be truly single if confidence in the safety of bank deposits is the same irrespective of the Member State in which a bank operates. This requires single bank supervision, single bank resolution and single deposit insurance. This is also crucial to address the bank sovereign negative feedback loops which were at the heart of the crisis.

The Treaty defines the instruments for managing EMU. These instruments cover the main economic activities described above.

Monetary policy

Monetary policy for the euro area is managed through the European Central Bank and the national central banks of the euro-area Member States, which together make up the Eurosystem. Decisions on monetary policy in the euro area can only be taken by the Governing Council of the ECB, which comprises the governors of the national central banks of the euro-area Member States and the members of the ECB’s Executive Board. These decisions are made free from outside influence. EU Member States outside the euro area coordinate their monetary policy with the ECB within the European System of Central Banks.

The Treaty lays down the ECB’s mission which is to ensure price stability within the euro area. The ECB aims to keep price inflation in the euro area below but close to 2% over the medium term. This 2% inflation target is considered optimal for promoting growth and employment.

The Stability and Growth Pact (SGP)

Economic policy-making in Member States is coordinated in the Council. The Stability and Growth Pact (SGP), laid down in the Treaty, is a central element of this coordination. Adopted by the Council in 1997 and later revised in 2005 and 2011, the SGP helps enforce fiscal discipline within EMU and ensure sound and sustainable public finances.

The SGP requires government deficits and debt to be less than 3% and 60% of GDP, respectively. Exceeding these limits can result in an excessive deficit procedure requiring the Member State to take corrective action. The euro-area countries can also be subject to financial penalties as a last resort. This constitutes the 'corrective arm' of the SGP. There are circumstances where excessive deficits are considered exceptional and temporary, such as when they result from a severe economic downturn or are due to the major impact of an unusual event outside government's control.

The SGP also has a 'preventive arm' which aims to avoid excessive deficit procedures and achieve fiscal consolidation through medium-term budgetary objectives. These are set by each Member State according to its particular economic situation and prospects, but cannot exceed 1% of GDP for euro-area Member States and those which participate in the exchange rate mechanism (ERM II), with a 0.5% of GDP budgetary correction towards the objective to be made each year. The preventive arm has no sanctions for those Member States which fail to meet their objectives, but rather counts on peer pressure to encourage governments to stick to the path towards sustainable budgets.

For more details, visit the pages dedicated to the Stability and Growth Pact

The Broad Economic Policy Guidelines

Wider coordination is achieved through annual cycles of economic policy discussions between Member States and EU institutions. This policy coordination is consolidated into the Broad Economic Policy Guidelines (BEPG) which are adopted by the EU Council on the basis of a Commission recommendation. The BEPG are updated annually and cover the coming three years.

The BEPG are non-binding guidelines for the Community and each Member State aimed at promoting macroeconomic stability, sustainable finances, structural reform and the smooth functioning of EMU. The Guidelines serve the aim of the European Semester of economic policy coordination, as they frame the scope and direction for Member States’ national reform programmes (NRP) and serve as reference for the development for Country Specific Recommendations (CSR).