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Copyright 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 20

OptimumCurrency Areasand theEuropeanExperience

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Copyright 2012 Pearson Addison-Wesley. All rights reserved.20-2

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The European Union

The European Monetary System

Policies of the EU and the EMS Theory of optimal currency areas

Is the EU an optimal currency area?

Other considerations of an economic andmonetary union

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What Is the EU?

The European Union is a system of internationalinstitutions, the first of which originated in 1957,which now represents 27 European countriesthrough the following bodies:

European Parliament:elected by citizens of member countries

Council of the European Union:appointed by governmentsof the member countries

European Commission:executive body

Court of Justice:interprets EU law

European Central Bank, which conducts monetary policythrough a system of member country banks called theEuropean System of Central Banks

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What Is the EMS?

The European Monetary Systemwas originally asystem of fixed exchange rates implemented in1979 through an exchange rate mechanism(ERM).

The EMS has since developed into an economicand monetary union (EMU), a more extensivesystem of coordinated economic and monetarypolicies.

The EMS has replaced the exchange rate mechanism formost members with a common currency under theeconomic and monetary union.

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Copyright 2012 Pearson Addison-Wesley. All rights reserved. 20-5

Membership of theEconomic and Monetary Union

To be part of the economic and monetary union,EMS members must

1. adhere to the ERM: exchange rates were fixed inspecified bands around a target exchange rate.

2. follow restrained fiscal and monetary policies asdetermined by Council of the European Union and theEuropean Central Bank.

3. replace the national currency with the euro, whosecirculation is determined by the European System of

Central Banks.

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Membership of the EU

To be a member of the EU, a countrymust, among other things,

1. have low barriers that limit trade and flows of

financial assets2. adopt common rules for emigration and

immigration to ease the movement of people

3. establish common workplace safety and

consumer protection rules4. establish certain political and legal institutions

that are consistent with the EUs definition ofliberal democracy.

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Fig. 20-1: Members of the Euro Zone as ofJanuary 1, 2011

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Table 20-1: A Brief Glossary of Euronyms

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Why the EU?

Countries that established the EU and EMS hadseveral goals

1. To enhance Europespower in international affairs:as a union of countries, the EU could represent more

economic and political power in the world.

2. To make Europe a unified market: a large market withfree trade, free flows of financial assets, and freemigration of peoplein addition to fixed exchange ratesor a common currencywas believed to foster economicgrowth and economic well-being.

3. To make Europe politically stable and peaceful.

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Why the Euro (EMU)?

EU members adopted the euro for 4 main reasons:

1. Unified market: the belief that greater marketintegration and economic growth would occur.

2. Political stability: the belief that a common currency

would make political interests more uniform.3. The belief thatGerman influenceunder the EMS

would be moderatedunder a European System ofCentral Banks.

4. Elimination of the possibility of devaluations/revaluations: with free flows of financial assets, capitalflight and speculation could occur in an EMS withseparate currencies, but it would be more difficult forthem to occur in an EMS with a single currency.

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The EMS 19791998

From 1979 to 1993, the EMS defined the exchangerate mechanism to allow most currencies tofluctuate +/2.25% around target exchange rates.

The exchange rate mechanism allowed largerfluctuations (+/6%) for currencies of Portugal,Spain, Britain (until 1992) and Italy (until 1990).

These countries wanted greater flexibility with monetarypolicy.

The wider bands were also intended to prevent speculationcaused by differing monetary and fiscal policies.

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The EMS 19791998 (cont.)

To prevent speculation,

early in the EMS some exchange controlswerealso enforced to limit trading of currencies.

But from 1987 to 1990 these controls were lifted in orderto make the EU a common market for financial assets.

A credit systemwas also developed among EMSmembers to lend to countries that needed assets

and currencies that were in high demand in theforeign exchange markets.

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But because of differences in monetary and fiscalpolicies across the EMS, market participants beganbuying German assets (because of high Germaninterest rates) and selling other EMS assets.

As a result, Britain left the EMS in 1992 andallowed the pound to float against other Europeancurrencies.

As a result, the exchange rate mechanism wasredefined in 1993 to allow for bands of +/15% ofthe target value in order devalue many currenciesrelative to the deutschemark.

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But eventually, each EMS member adoptedsimilarly restrained fiscal and monetary policies,and the inflation rates in the EMS eventuallyconverged (and speculation slowed or stopped).

In effect, EMS members were following the restrainedmonetary policies of Germany, which has traditionally hadlow inflation.

Under the EMS exchange rate mechanism of fixed bands,Germany was exporting its monetary policy.

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Fig. 20-2: Inflation Convergence for SixOriginal EMS Members, 19782009

Source: CPI inflation rates from International Monetary Fund, International Financial Statistics.

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Policies of the EU and EMS

TheSingle European Act of 1986recommendedthat many barriers to trade, financial asset flows,and immigration be removed by December 1992. It also allowed EU policy to be approved with less than

unanimous consent among members.

TheMaastricht Treaty, proposed in 1991, requiredthe 3 provisions to transform the EMS into aneconomic and monetary union.

It also required standardizing regulations and centralizingforeign and defense policies among EU countries.

Some EU/EMS members have not ratified all of theclauses.

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Policies of the EU and EMS (cont.)

The Maastricht Treaty requires that membersthat want to enterthe economic and monetaryunion

1. attain exchange rate stability defined by the ERMbefore adopting the euro.

2. attain price stability: a maximum inflation rate of1.5% above the average of the three lowest

national inflation rates among EU members.3. maintain a restrictive fiscal policy:

a maximum ratio of government deficit to GDP of 3%.

a maximum ratio of government debt to GDP of 60%.

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The Maastricht Treaty requires that membersthat want to remainin the economic andmonetary union

1. maintain a restrictive fiscal policy:

a maximum ratio of government deficit to GDP of 3%.

a maximum ratio of government debt to GDP of 60%.

Financial penalties are imposed on countries withexcessive deficits or debt.

The Stability and Growth Pact, negotiated in1997, also allows for financial penalties oncountries with excessive deficits or debt.

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The euro was adopted in 1999, and the previousexchange rate mechanism became obsolete.

But a new exchange rate mechanismERM 2was

established between the economic and monetaryunion and outside countries.

It allowed countries (either within or outside of the EU)that wanted to enter the economic and monetary union inthe future to maintain stable exchange rates before doing

so.

It allowed EU members outside of the economic andmonetary union to maintain fixed exchange rates ifdesired.

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Theory of Optimum Currency Areas

The theory of optimum currency areasarguesthat the optimal area for a system of fixedexchange rates, or a common currency, is one thatis highly economically integrated.

economic integration means free flows of

goods and services (trade)

financial capital (assets) and physical capital

workers/labor (immigration and emigration)

The theory was developed by Robert Mundell in1961.

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Theory of Optimum Currency Areas(cont.)

Fixed exchange rates have costs and benefits forcountries deciding whether to adhere to them.

Benefits of fixed exchange rates are that

they avoid the uncertainty and internationaltransaction costs that floating exchangerates involve.

The gain that would occur if a country joined a

fixed exchange rate system is called themonetary efficiency gain.

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In general, as the degree of economic integrationincreases, the monetary efficiency gain increases.

Draw a graph of the monetary efficiency gain as a

function of the degree of economic integration.

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Fig. 20-3: The GGSchedule

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When considering the monetary efficiency gain,

we have assumed that the members of the fixedexchange rate system would maintain stable

prices. But when variable inflation exists among member countries,

then joining the system would not reduce uncertainty(as much).

we have assumed that a new member would be

fully committed to a fixed exchange rate system. But if a new member is likely to leave the fixed exchange rate

system, then joining the system would not reduce uncertainty(as much).

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Economic integration also allows prices toconverge between members of a fixed exchangerate system and a potential member.

The law of one price is expected to hold better whenmarkets are integrated.

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Costs of fixed exchange rates are that they requirethe loss of monetary policy for stabilizing outputand employment, and the loss of automaticadjustment of exchange rates to changes in

aggregate demand.

Define this loss that would occur if a countryjoined a fixed exchange rate system as theeconomic stability loss.

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The economic stability loss of joining a fixedexchange rate system also depends on theamount of economic integration.

After joining a fixed exchange rate system, if thenew member faces a fall in aggregate demand:

1. Relative prices will tend to fall, which will lead othermembers to increase aggregate demand greatly ifeconomic integration is extensive, so that the economic

loss is not as great.

2. Financial assets or labor will migrate to areas withhigher returns or wages if economic integration isextensive, so that the economic loss is not as great.

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3. The loss of the automatic adjustment of flexibleexchange rates is not as great if goods and servicesmarkets are integrated. Why?

Consider what would have happened if the

country did not join the fixed exchange ratesystem:

the automatic adjustment would have caused adepreciation of the domestic currency and an

appreciation of foreign currencies, which would havecaused an increase in many prices for domesticconsumers when goods and services markets areintegrated.

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In general, as the degree of economic integrationincreases, the economic stability loss decreases.

Draw a graph of the economic stability loss as a

function of the degree of economic integration.

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At some critical point measuring the degree ofintegration, the monetary efficiency gain willexceed the economic stability loss for a memberconsidering whether to join a fixed exchange rate

system.

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Fig. 20-5: Deciding When to Peg theExchange Rate

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There could be an event that causes the frequencyor magnitude of changes in aggregate demand toincrease for a country.

If so, the economic stability loss would be greaterfor every measure of economic integrationbetween a new member and members of a fixedexchange rate system.

How would this affect the critical point where themonetary efficiency gain equals economic stabilityloss?

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Fig. 20-6: An Increase in OutputMarket Variability

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Is the EU an Optimum Currency Area?

If the EU/EMS/economic and monetary union canbe expected to benefit members, we expect thatits members have a high degree of economicintegration:

large trade volumes as a fraction of GDP

a large amount of foreign financial investmentand foreign direct investment relative to total investment

a large amount of migration across borders as a fraction

of total labor force

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Is the EU an Optimum Currency Area?(cont.)

Most EU members export from 10% to 20% ofGDP to other EU members

This compares with exports of less than 2% of EU GDP tothe U.S.

But trade between regions in the U.S. is a larger fractionof regional GDP.

Was trade restricted by regulations that wereremoved under the Single European Act?

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Fig. 20-7: Intra-EU Trade as aPercent of EU GDP

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Regional migration is not extensive in the EU.

Europe has many languages and cultures, whichhinder migration and labor mobility.

Unions and regulations also impede labormovements between industries and countries.

Differences of U.S. unemployment rates acrossregions are smaller and less persistent than

differences of national unemployment rates in theEU, indicating a lack of EU labor mobility.

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Table 20-2: People Changing Region ofResidence in the 1990s (percent of total

population)

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Fig. 20-8: Divergent Real Interest Ratesin the Euro Zone

Source: Datastream.

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Table 20-3: Current Account Balances ofEuro Zone Countries, 20052009 (percent

of GDP)

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There is evidence that financial assets were ableto move more freely within the EU after 1992 and1999.

But capital mobility without labor mobility canmake the economic stability loss greater.

After a reduction of aggregate demand in a particular EUcountry, financial assets could be easily transferredelsewhere while labor is stuck.

The loss of financial assets could further reduceproduction and employment.

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Other Considerations for an EMU

The structure of the economiesin the EUseconomic and monetary union is importantfor determining how members respond toaggregate demand shocks.

The economies of EU members are similar in thesense that there is a high volume of intra-industry traderelative to the total volume.

They are different in the sense that Northern

European countries have high levels of physicalcapital per worker and more skilled labor,compared with Southern European countries.

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Other Considerations for an EMU (cont.)

How an EU member responds to aggregatedemand shocks may depend on how thestructure of its economy compares to that offellow EU members.

For example, the effects on an EU member of areduction in aggregate demand caused by areduction in demand in the software industrywill depend on whether the EU member has alarge number of workers skilled in programmingrelative to fellow EU members.

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Other Considerations for an EMU (cont.)

The amount of transfersamong the EUmembers may also affect how EUeconomies respond to aggregate demandshocks.

Fiscal payments between countries in the EUsfederal system, or fiscal federalism, may helpoffset the economic stability loss from joiningan economic and monetary union.

But relative to interregional transfers in theU.S., little fiscal federalism occurs among EUmembers.

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Summary

1. The EMS was first a system of fixed exchangerates but later developed into a more extensivecoordination of economic and monetary policies:an economic and monetary union.

2. The Single European Act of 1986 recommendedthat EU members remove barriers to trade,capital flows, and immigration by the end of1992.

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Summary (cont.)

3. The Maastricht Treaty outlined 3 requirements forthe EMS to become an economic and monetaryunion.

It also standardized many regulations and gave the EUinstitutions more control over defense policies.

It also set up penalties for spendthrift EMU members.

4. A new exchange rate mechanism was defined in1999 vis--vis the euro, when the euro came intoexistence.

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Summary (cont.)

5. An optimum currency area is a union of countrieswith a high degree of economic integrationamong goods and services, financial assets, andlabor markets.

It is an area where the monetary efficiency gain ofjoining a fixed exchange rate system is at least as largeas the economic stability loss.

6. The EU does not have a large degree of labormobility due to differences in culture and due to

unionization and regulation.

7. The EU is not an optimum currency area.

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