Slide 20-1Copyright © 2003 Pearson Education, Inc.  European Union countries have progressively narrowed the fluctuations of their currencies against each other. Birth of the euro: January 1,  Questions and concerns How and why did Europe set up its single currency? Will the euro be good for the economies of its members? How will the euro affect countries outside of the European Monetary Union (EMU)? What lessons does the European experience carry for other potential currency blocks?

Slide 20-2Copyright © 2003 Pearson Education, Inc. Members of the Euro Zone as of January 1, 2001

Slide 20-3Copyright © 2003 Pearson Education, Inc. A Brief Glossary of Euronyms: Eurotalk How the European Single Currency Evolved

Slide 20-4Copyright © 2003 Pearson Education, Inc. How the European Single Currency Evolved European Currency Reform Initiatives, The Werner report (1969) –Eliminate intra-European exchange rate movements –Centralize EU monetary policy decisions –Lower remaining trade barriers within Europe Two major reasons for adopting the Euro: –To enhance Europe’s role in the world monetary system –To turn the European Union into a truly unified market

Slide 20-5Copyright © 2003 Pearson Education, Inc.  The European Monetary System,  Exchange Rate Mechanism (ERM) Germany, the Netherlands, Belgium, Luxemburg, France, Italy, and Britain participated in an informal joint float against the dollar known as the “snake.” –Most exchange rates could fluctuate up or down by as much as 2.25% relative to an assigned par value. –Others had wider range  Snake in the Tunnel How the European Single Currency Evolved

Slide 20-6Copyright © 2003 Pearson Education, Inc. Capital controls and frequent realignments essential to EMS until mid-1980s. –After the mid-1980s, controls abolished as part of the EU’s “1992” program  “market unification”. September 1992 Currency Crisis, Britain, Italy, and Sweden allowed their currencies to float. August 1993: most EMS currency bands widened to ± 15% in the face of continuing speculative attacks. How the European Single Currency Evolved

Slide 20-7Copyright © 2003 Pearson Education, Inc.  German Monetary Dominance  Germany has low inflation and an independent central bank (Bundesbank). –It also has the reputation for tough anti-inflation policies. Credibility theory of the EMS –By fixing their currencies to the DM, the other EMS countries imported the Buba’s credibility as an inflation fighter. –Inflation rates in EMS countries tended to converge around Germany’s generally low inflation rate. How the European Single Currency Evolved

Slide 20-8Copyright © 2003 Pearson Education, Inc. Inflation Convergence Within Six Original EMS Members,

Slide 20-9Copyright © 2003 Pearson Education, Inc.  The EU “1992” Initiative EU internal economic unity: –Fix mutual exchange rates –The Single European Act, 1986: “Four Freedoms”  free movement of people, goods, services, and capital and established many new policies.  Delors Report, 1989, laid the foundations for the single currency, the euro. Economic and monetary union (EMU) How the European Single Currency Evolved

Slide 20-10Copyright © 2003 Pearson Education, Inc. Three stages of Delors plan: –All EU members join the EMS exchange rate mechanism (ERM) –Exchange rate margins narrowed and certain macroeconomic policy decisions placed under more centralized EU control –Replacement of national currencies euro, with monetary policy controlled by a ESCB (European System of Central Banks) How the European Single Currency Evolved

Slide 20-11Copyright © 2003 Pearson Education, Inc. Maastricht Treaty (1991) –Blueprint for the transition process from the EMS fixed exchange rate system to EMU. –Macroeconomic convergence criteria for admission to EMU. –Harmonize social policy within the EU –Centralize EU foreign and defense policy How the European Single Currency Evolved

Slide 20-12Copyright © 2003 Pearson Education, Inc.  The Maastricht Convergence Criteria and the Stability and Growth Pact –Price stability –Maximum inflation rate 1.5% above the average of the three EU member states with lowest inflation –Exchange rate stability –Stable exchange rate within the ERM without devaluing on its own initiative –Budget discipline –Maximum public-sector deficit 3% of the country’s GDP –Maximum public debt 60% of the country’s GDP

Slide 20-13Copyright © 2003 Pearson Education, Inc. Behavior of the Euro’s Exchange Rates Against Major Currencies

Slide 20-14Copyright © 2003 Pearson Education, Inc. Robert Mundell: The Theory of Optimum Currency Areas  Fixed exchange rates most appropriate for areas closely integrated through international trade and factor movements. Monetary efficiency gain –Avoid uncertainty, confusion, and calculation and transaction costs when exchange rates float. –Rises with the degree of economic integration between the joining country and the fixed exchange rate area. GG schedule shows the potential gain of a country from joining the euro zone depends on its trading link with the zone  GG slopes upward.

Slide 20-15Copyright © 2003 Pearson Education, Inc. The Theory of Optimum Currency Areas Figure 20-4: The GG Schedule Degree of economic integration between the joining country and the exchange rate area Monetary efficiency gain for the joining country GG

Slide 20-16Copyright © 2003 Pearson Education, Inc. Economic Integration and Costs of a Fixed Exchange Rate Area: The LL Schedule Economic stability loss –Country that joins an exchange rate area cannot use exchange rate and monetary policy to stabilize output and employment. –Loss is lower, the higher the degree of economic integration between a country and the fixed exchange rate area that it joins. –Loss is lower the more symmetrical the shocks LL schedule slopes downward.

Slide 20-17Copyright © 2003 Pearson Education, Inc. The Theory of Optimum Currency Areas Figure 20-5: The LL Schedule Degree of economic integration between the joining country and the exchange rate area Economic stability loss for the joining country LL

Slide 20-18Copyright © 2003 Pearson Education, Inc.  The Decision to Join a Currency Area: Putting the GG and LL Schedules Together The intersection of GG and LL –Determines a critical level of economic integration between a fixed exchange rate area and a country –Shows how a country should decide whether to fix its currency’s exchange rate against the euro The Theory of Optimum Currency Areas

Slide 20-19Copyright © 2003 Pearson Education, Inc. Deciding When to Peg the Exchange Rate Degree of economic integration between the joining country and the exchange rate area Gains and losses for the joining country LL GG Gains exceed losses Losses exceed gains 11 1

Slide 20-20Copyright © 2003 Pearson Education, Inc. An Increase in Output Market Variability LL 1 GG LL 2 2 22 Degree of economic integration between the joining country and the exchange rate area Gains and losses for the joining country 11 1

Slide 20-21Copyright © 2003 Pearson Education, Inc. The Theory of Optimum Currency Areas Intra-EU Trade as a Percent of EU GDP

Slide 20-22Copyright © 2003 Pearson Education, Inc. The Theory of Optimum Currency Areas People Changing Region of Residence in 1986 (percent of total population)

Slide 20-23Copyright © 2003 Pearson Education, Inc. Case Study: Is Europe an Optimum Currency Area? Europe is not an optimum currency area: –Most EU countries export form 10% to 20% of their output to other EU countries. –EU-U.S. trade is only 2% of U.S. GNP. –Labor is much more mobile within the U.S. than within Europe. –Federal transfers and changes in federal tax payments provide a much bigger cushion for region-specific shocks in the U.S. than do EU revenues and expenditures.

Slide 20-24Copyright © 2003 Pearson Education, Inc. The Theory of Optimum Currency Areas Figure 20-9: Divergent Inflation in the Euro Zone

Slide 20-25Copyright © 2003 Pearson Education, Inc. The Future of EMU  If EMU succeeds it will promote European political as well as economic integration.  If EMU fails the goal of European political unification will be set back.  Problems that the EMU will face in the coming years: Europe is not an optimum currency area. Economic union is so far in front of political union. EU labor markets are very rigid. SGP constrains fiscal policies.