1. The Single European Currency
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2. Key Issues Which countries have joined the Euro Zone?
Why have convergence criteria?
What are the basic effects of a single currency?
What are the motivations for joining the Euro?
The case for UK entry
The case against UK entry
Optimal currency areas
Tensions for the single currency in

3. Britain and the Euro – The Current Position (2009)
Britain is outside of the Euro Zone
It has an opt out from the single currency
No entry likely in the coming years
Important point: Even though the UK is outside of the Euro Zone, the UK cannot be isolated from the static and dynamic effects of the Single European Currency
Arguments continue to rage as to whether the twelve countries within the Euro Zone stand to benefit from a ‘one-size fits all monetary policy’. Are they sufficiently similar (or convergent) in terms of economic performance for the benefits of Euro membership to outweigh the costs of having to accept a single rate of interest?

4. Back to Basics on the Euro
A single currency requires a common interest rate for the Euro Zone – i.e. a common monetary policy
16 member nations are inside the Euro Area
The European Central Bank (ECB) sets official interest rates to meet an inflation target of 2%
The approach of ECB is different to that of the USA Federal Reserve (dual target)
The US Federal Reserve tends to set interest rates to maintain growth and avoid deflation
The ECB is in charge of setting a common interest rate for the twelve countries inside the Euro Zone. The main policy objective is to achieve price stability – defined as “a year-on-year increase in the Harmonised Index of Consumer Prices of below 2%”.

5. Central Bankers Janet Yellen Chair of the Federal Reserve Mark Carney
Governor of the Bank of England
Mario Draghi
President of the European Central Bank

6. Euro Zone Interest Rates
The ECB targets the growth of the broad money supply as a guide to the future direction of interest rates. Broad money is basically determined by the growth of bank deposits – the majority of which are created through bank loans and over-drafts. The ECB does not have an exchange rate target, although it has intervened on a few occasions to influence the external value of the Euro

7. Judging the Success of the Euro
The Euro project should be judged according to whether it achieves its long term aims
(1) Sustained non-inflationary growth
(2) Lower long-term interest rates and higher rates of investment
(3) Lower unemployment
(4) Expansion of the EU single market
The Euro on its own in insufficient to achieve these – structural economic reforms in Europe are also required and many are taking place

8. Convergence Criteria – Joining the Euro
Flexibly applied for original Euro members – but more strictly applied in the case of new member states
Inflation:
Average inflation over previous year must not exceed by more than 1.5% that of the three lowest inflation countries
Government Finances
Budget deficit must not exceed 3% of GDP
Gross government debt must not exceed 60% of GDP
Interest Rates:
Average yield on govt bonds must not exceed by more than 2% bond yields of three lowest inflation countries
Exchange Rate Stability:
Currency must have adhered to fluctuation margins of the ERM II in two previous years without severe tension

9. Inflation convergence – Slovakia

10. Nominal v Real (Structural) Convergence
Nominal Economic Indicators
(Those required under the Maastricht Treaty)
Consumer price inflation
Short term interest rates
Fiscal (Budget) deficit
Gross government debt
Exchange rate stability
Structural convergence analyses whether the supply-side structures of the British economy might be different to countries within the Euro Area. And, if they are, the extent to which different structures could make the UK more vulnerable to economic shocks that do not affect the rest of the euro area (for example, volatility in house prices). There is also the risk that the UK could react differently to changes in circumstances that affect the whole of the monetary union (e.g. changes in Euro Zone interest rates).

11. Nominal v Real (Structural) Convergence
Nominal Economic Indicators
(Those required under the Maastricht Treaty)
Consumer price inflation
Short term interest rates
Fiscal (Budget) deficit
Gross government debt
Exchange rate stability
Real Economic Indicators
(Important in the long term)
Trend growth of GDP
Labour market performance
Trend growth of labour productivity
Trade balances in goods and services
Investment/GDP ratios
Housing market structure
Structural convergence analyses whether the supply-side structures of the British economy might be different to countries within the Euro Area. And, if they are, the extent to which different structures could make the UK more vulnerable to economic shocks that do not affect the rest of the euro area (for example, volatility in house prices). There is also the risk that the UK could react differently to changes in circumstances that affect the whole of the monetary union (e.g. changes in Euro Zone interest rates).

12. Optimal Currency Areas (OCA)
Is the Euro Zone an optimal currency area?

13. Is the Euro an Optimal Currency Zone?
An optimal currency zone occurs when:
(1) Countries have achieved real convergence
(2) They respond in similar ways to external economic shocks or macro policy changes
(3) They have sufficient flexibility in both their product markets and labour markets to deal with these shocks
High geographical mobility of labour
High occupational mobility of labour
Wage and price flexibility in factor markets
(4) Countries are prepared to use fiscal transfers to even out some of the regional economic imbalances within the European currency union
he concept of an optimal currency area (OCA) is important to the debate about the Euro. An OCA works best when the countries within it are already highly integrated with each other and where each has a sufficiently flexible labour market to cope with external economic shocks. The OCA is also likely to work well when the monetary policy transmission mechanism works in similar ways within each country – in other words, the effects of interest rate changes have a broadly similar impact on businesses and households, and the time lags involved in interest rate changes working their way through to affect output, employment and prices are pretty close to each other.

14. Optimal Currency Zones (2)
By most criteria, the current Euro Zone does not come close to an optimal currency zone!
The core group of EU countries are broadly similar (Germany + France + Netherlands + Belgium)
But peripheral countries have big structural differences
And there are barriers to the mobility of labour
Little wonder that tensions are rising in the Euro Area as recession bites
In most important respects, the Euro Zone is not an OCA – although a small group of countries within it are probably closely convergent in a structural sense. An OCA is better placed to succeed with a small cluster of countries rather than the looser coalition of twelve nations that count themselves as founder members of the single currency.

15. Optimal Currency Zones
Highly Flexible
Labour Market Flexibility
Inflexible
Divergent
Real Economic Convergence
Convergent

16. Optimal Currency Zones
Highly Flexible
Labour Market Flexibility
High risk currency union
Inflexible
Divergent
Real Economic Convergence
Convergent

17. Optimal Currency Zones
Monetary Union Works
Highly Flexible
Labour Market Flexibility
High risk currency union
Inflexible
Divergent
Real Economic Convergence
Convergent

18. Is the Euro an Optimal Currency Zone?
Professor Robert Mundell
The 1999 Nobel Prize Winner
"for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas"

19. Tensions in the Euro Area (2)
Recession in Euro Area as a whole (-2% in 2009)
Riots and protests
Fears of deep cuts in real wages
Rising unemployment
Strong Euro making life very tough for exporters
Many peripheral Euro Area countries are struggling e.g. Greece, Ireland, Italy, Portugal and Spain
Huge divergence in competitiveness showing up in massive trade imbalances
But no chance of nominal exchange rate adjustment
So downward pressure on wages and jobs

20. Tensions in the Euro Area (1)
Fiscal policy is coming under pressure:
Bail outs for financial institutions
But smaller EU states have little chance of doing this
Cross-border contamination e.g. heavy investment into CEEC’s by Austrian banks
Downgrading of credit rating for several Euro Area countries including Spain and Greece
Makes it more expensive for companies and the government to finance borrowing
Think of consequences for investment and growth
What happens if one or more countries leave and devalue their way to an economic recovery?

21. Case for Entry into the Euro

22. Microeconomic Benefits of Entry
The Euro is important in realising some of the gains from a functioning single market
(1) Potential Gains for consumers
Lower prices because of increased competition/ greater price transparency (this is more likely with easily transportable goods)
Reduction in the transactions costs of travelling within Europe (e.g. costs of currency exchange)
Easier to live and work in different EU countries
Membership of the Euro should in practice make it easier for consumers and businesses to compare relative prices levels across member nations. This will encouraged increase cross-border trade and increase the competitive pressures across many different markets. There are potential gains in consumer welfare if price transparency leads to improvements in allocative efficiency.

23. Microeconomic Benefits of UK Entry
(2) Potential gains for businesses
Invoicing can be done with one currency
Lower transactions costs – some people argue that staying out of the Euro is equivalent to exporters facing a tariff when they trade inside the EU
Gains for the tourist industry in attracting overseas visitors
Businesses might be able to fund their capital investment at lower real interest rates
The Euro is vital as a complement to the success of the Single European Market. This should lead to an increase in intra-European trade flows and higher inward investment within the EU region. Britain stands to gain from this, particularly if she can maintain low cost and price inflation and raise productivity of British firms operating in competitive European markets.

24. The Case for Staying Outside the Euro Zone

25. Microeconomic Disadvantages
(1) Changeover Costs from joining the Euro:
Costs of changing accounting systems
Menu Costs (vending machines, catalogues, franking machines, postage
Installation of new payments systems
Customer confusion (imperfect information)
(2) Higher prices
Potential loss of consumer welfare if suppliers increase prices when converting from sterling to euro
(3) The vast majority of consumers will continue to buy locally – what matters more is the effectiveness of competition policy in targeting anti-competitive behaviour

26. Macroeconomic Case Against Entry
(1) Entering the Euro means losing an instrument of policy adjustment
A “one-size fits all” monetary policy may work against a country if their cycle is not convergent with Euro Zone
Retaining the option of making an exchange rate adjustment is useful
(2) Fiscal Policy constraints
The EU Growth and Fiscal Stability Pact
Limits on government borrowing
But now largely ignored – especially with the effects of the credit crunch / fiscal bail-outs etc
Critics of the Euro argue that the new currency does not meet the requirements of an optimal currency area and that structural economic differences between member nations threaten to undermine the success of the project. Other economists believe that the UK can continue to enjoy a sustained period of macroeconomic prosperity outside the Euro Zone whilst still deriving some of the benefits from participation in the single European market.

27. Expansion of the Euro Zone
Slovenia joined in 2007
Cyprus and Malta joined in January 2008
Slovakia joined in January 2009
Latvia narrowly missed out on the convergence criteria
Other countries have delayed their entry
What are the arguments for the new member states entering the single currency?