Special Topics in Economics Econ. 491 Chapter 5: Convergence Criteria

I. Maastricht Criteria  The Maastricht criteria (also known as the convergence criteria) are the criteria for European Union member states to enter the third stage of European Economic and Monetary Union (EMU) and adopt the euro as their currency.  The Maastricht criteria stress three main policies: 1- Attain exchange rate stability defined by ERM (before Euro). 2- Attain price stability 3- Maintain a restrictive fiscal policy

II. Maastricht Convergence Indicators  Courtiers must conform to rules regarding exchange rate stability, inflation, interest rates, government budget deficits, and government debt.  These are called convergence indicators or convergence criteria.  They measure whether the economies follow policies similar-or convergent- enough to make a common currency viable.  All countries that satisfied the criteria were to embark on currency on currency unification as of January 1 st, Other EU members could join later as they met the convergence criteria.

 The Maastricht treaty requires each EU country to meet five convergence criteria to participate in monetary unification: 1. Currency must have remained within its ERM trading band for at least two years with no realignment. 2. Inflation rate for the preceding year must have been no more than 1.5% above the average inflation rate of the three lowest –inflation EU members. 3. Long term interest rate on government bonds during the preceding year must have been no more 2% above the average interest rate of the three lowest inflation EU members. 4. Budget deficit must not exceed 3% of GDP. 5. Government debt must not exceed 60% of GDP.

1. Currency must have remained within its ERM trading band for at least two years with no realignment: Joined the exchange rate mechanism of the EMS and did not experience a devaluation during the two years preceding the entrance into EMU 2. Inflation rate for the preceding year must have been no more than 1.5% above the average inflation rate of the three lowest –inflation EU members: Inflation rate  average of three lowest inflation rates in the group of candidate countries + 1.5%

3.Long term interest rate on government bonds during the preceding year must have been no more 2% above the average interest rate of the three lowest inflation EU members: Long-term interest rate  average observed in the three low-inflation countries + 2% Long-term interest rate  average observed in the three low-inflation countries + 2% 4.Budget deficit must not exceed 3% of GDP: Government budget deficit  3% of its GDP; If this condition is not satisfied: budget deficit should be declining continuously and substantially and come close to the 3% norm or the deviation from the reference value (3%) 'should be exceptional and temporary and remain close to the reference value', art. 104c(a))

5. Government debt must not exceed 60% of GDP: Government debt  60%of GDP; Government debt  60%of GDP; If this condition is not satisfied: If this condition is not satisfied: government debt should diminish sufficiently and approach the reference value (60%) at a satisfactory pace', art. 104c(b))

III. Why Convergence Requirements  The OCA theory stresses micro-economic conditions for a successful monetary union  Symmetry of shocks  Labour market flexibility  Labour mobility  The Treaty stresses macro-economic convergence  Inflation  Interest rates  Budgetary policies

 Exchange rate convergence (no-devaluation requirement) ;  It prevents countries from manipulating their exchange rates.  So as to have more favorable (depreciated) exchange rate in the union.  According to the Treaty, countries should maintain their exchange rates within the 'normal' band of fluctuation (without changing that band) during the two years preceding their entry into the EMU.

 Deficit and debt criteria can be rationalized in a similar way;  A country with a high debt-to-GDP ratio has an incentive to create surprise inflation  The low debt country stands to lose and will insist that the debt-to-GDP ratio of the highly indebted country be reduced prior to entry into the monetary union  The high debt country must also reduce its government budget deficit

 Countries with a large debt face a higher default risk;  Once in the union, this will increase the pressure for a bailout in the event of a default crisis.  No-bailout clause was incorporated into the Maastricht Treaty.  But is this clause credible?

 Interest rate convergence;  Excessively large differences in the interest rates prior to entry could lead to large capital gains and losses at the moment of entry into EMU  However, these gains and losses are likely to occur prior to entry because the market will automatically lead to a convergence of long term interest rates as soon as the political decision is made to allow entry of the candidate member country

IV. How to fix the conversion rates during the transition  Madrid Council of 1995 implied that on 1 January 1999 one ECU would be converted into one Euro  At the same time the conversion rates of the national currencies into the Euro had to be equal to the market rates of these currencies against the ECU at the close of the market on 31 December 1998  This created potential for self-fulfilling speculative movements of the exchange rates prior to 31 December 1998.

 The effect of such speculative movements could be to permanently fix the wrong values of the exchange rates.  In order to avoid this, the fixed rates at which the currencies would be converted into each other at the start of EMU were announced in advance;  If these announcements were credible, the market would smoothly drive the market rates towards the announced fixed conversion rates  This is exactly what happened. The authorities announced the fixed bilateral conversion rates in May 1998  Transition was very smooth with minimal turbulence

V. Calculating the Common Currency (Unified Currency)  It is possible to define the par value of the unified currency.  One method to calculate the par value of the unified currency is based on the weighted GDP.  The other method to calculate the par value of the unified currency is based on the weighted bilateral trade.  According to both methods, the exchange rate of the unified currency versus other external currencies is determined.  The exchange rate of the national currencies ( for the Monetary Union Members) versus the unified currency can also be determined.

Calculating the par value of the unified currency based on the weighted GDP. (1) Exchange Rate of US Dollar v.s National Currency ($/x) (2) Nominal GDP ( in million US Dollar) (3) The Weight ( # 2/ total) (3 X 1) Par Value Country A % Country B % Country C % Country D % Country E % Total

Calculating the Conversion Rates of the National Currencies versus the Unified Currency based on the weighted GDP. Conversion Rates of national Currencies v.s Unified Currency (National Currency /Unified Currency) Country A Country B Country C Country D Country E