Common Currency Areas and European Monetary Union

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A common currency area definition

A common currency area is a geographical area throughout which a single currency circulates as the medium of exchange.

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THE EURO

The European Economic and Monetary Union  is the European currency union that has adopted the euro as its common currency

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THE EURO

The Maastricht Treaty of 92

The euro officially came into existence on 1 January 1999 and on 1 January 2002 the first euro notes and coins began to circulate. 

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THE EURO

Economic and monetary union (EMU) was seen as necessary to complete the single European market (SEM).

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The Single Market and the Euro

  •       The European Union is  a family of democratic European countries, committed to working together for peace and prosperity.
  •      The Single European Market is an EU-wide market throughout which labour, capital, goods and services can move freely.
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The Single Market and the Euro

European Directives needed to do to achieve the following four goals:

  •       free movement of goods, services, labour and capital between member states;
  •        the approximation of relevant laws and administrative provisions between member states;
  •      a common EU-wide competition policy;
  •      and a system of common   external tariffs

 

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The Benefits of a Single Currency

  • Elimination of transaction costs
  • Reduction in price discrimination.
  • Reduction in foreign exchange rate variability.
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The Costs of a Single Currency

you have to give up 

  •     Its freedom to set its own monetary policy,
  •     Macroeconomic adjustment through movements in the external value of its currency.    
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The Costs of a Single Currency

Assume a shift in consumer preferences away from German goods in favour of French goods

agg d curve will shifit to 

left in Germany 

right in France 

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The Costs of a Single Currency

  • if Gove dose nothing= economies will return to natural rate of unemployment 
  •  If 2 countries has retained separate currencies - SR fluctuations in agg D been alleviated by movement in ER

     

 

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The Costs of a Single Currency

Without this adjustment mechanism

German policy makers cut in their IR to boost agg D

French policy makers more likely to favor rise in IR to contain inflation 

ECB would be unable to satisfy both countries.

 

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The Costs of a Single Currency

ECB pursues inflation as an targeting strategy

If a countries IR below euro land ave= monetary   policy too tight

If a country IR above ave= monetary policy too loose  

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THEORY OF OPTIMUM CURRENCY AREAS

key defAn optimum currency area is a group of countries for which it is optimal to adopt a common currency and form a currency union.

OCA= specify criteria for the optimality of a currency union for given group of countries  

The qualifier ‘optimal’ used loosly/ refers to the ability of countries concerned to limit the costs/ enhance the benefits  

  

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Characteristics That Reduce the Costs of a Single

  •      Real wage flexibility.
  •      Labour mobility
  •      Capital mobility
  •      Symmetric shocks.
  •      Trade integration.
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IS EUROPE AN OPTIMUM CURRENCY AREA?

We need to look at the degree of:

  •        Trade integration.
  •         Real wage flexibility.
  •         Labour mobility.
  •        Financial capability mobility.
  •         Symmetric demand shocks.
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Trade integration

  • quite high on average
  • been increasing over time
  • The rate of increase appears to have been greater since the currency union was established
  • probably significant gains from EMU.
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Real Wage Flexibility

Many European labour markets most rigid in the world

Uk one of most flexible

Intro of euro may have had negative effect on European open wage flexibility

  • Many collective wage agreements cover a firm’s workers in a number of EU countries.

A single currency brings transparency to wage differentials 

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Real Wage Flexibility

Europe scores very low on this OCA criterion

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Labour Mobility

labour is notoriously immobile across European countries.

Exception migration new eastern European members of the EU  

Even within individual euro area countries  Mobility much lower than USA

Europe scores very low on this OCA criterion

 

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Financial Capital Mobility

In gove bond markets yields on bonds similar / tend to move closely   together= high degree of integration

 Integration of retail financial markets is much less- Limited cross border retail banking

Persistent diff in bank lending rates of diff countries 

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Symmetric Demand Shocks

Economic cycle across euro land area positively correlated- timing of booms/ recessions seems to be V close

No clear evidence of asymmetric affecting these countries 

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So is Europe an Optimum Currency Area?

Econ cycles- broadly synchronised

Okay on the financial mobility, less good on labour mobility / wage flexibility.

Diff growth rates could exert pressure because eurozone countries can use independent monetary / ER tools to readjust.

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FISCAL POLICY AND COMMON CURRENCY AREAS

key def: Fiscal federalismis a fiscal system for a group of countries involving a common fiscal budget and system of fiscal transfers across countries.

  Problem= tax payers in 1 country not be happy to see their taxes spent on transfers to residents of another country

 

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National Fiscal Policies in a Currency Union: The

absence of fiscal federalism potential free rider problem. 

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National Fiscal Policies in a Currency Union: The

Inside  currency union- it might be expected that other members of union to bail out a gove that has borrowed heavily rather than see it default 

If financial market takes this view than IR penalty imposed will be less on high borrowing country

Other gove regarded as underwriters of the high borrowing government’s debt= pay higher interest rates  

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National Fiscal Policies in a Currency Union: The

, the high borrowing gove borrows more cheaply than it could outside of the currency union, / imposes costs on the other currency union members.

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National Fiscal Policies in a Currency Union: The

Currency union members can enter into ‘no bail-out’ agreements, there is an issue about the credibility of such agreements.

So a set of fiscal rules may be used instead -Stability and Growth Pact (SGP). 

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Case study: The Stability Growth Pact: A Ferocious

The main components of the SGP were

Members with a budget deficit of more than 3 per cent of GDP would be subject to fines of up to 0.5 per cent of GDP

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Case study: The Stability Growth Pact: A Ferocious

The choice of a maximum budget deficit of 3 per cent of GDP was related to the clause in the Maastricht Treaty 

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Fiscal Policy and Common Currency Areas

Having a system of rigid rules and fines, but no credible way of enforcing the sanctions, was not the correct way to ensure fiscal stability in the euro area.  The consequences of the financial crisis have made the limitation of the SGP even more clear.

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Fiscal Compact

The treaty came in force in January 2013. designed so avoid further problems of countries running up debts and to keep the euro area together. The treaty echoes some of the features of the SGP 

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