CHAPTER 20 Optimum Currency Areas and the European Experience

1. CHAPTER 20Optimum Currency Areas and the European Experience

2. Optimum Currency Areas and the European Experience • How the European Single Currency Evolved • The Euro and Economic Policy in the Euro Zone • The Theory of Optimum Currency Areas • The Future of EMU

3. How the European Single Currency Evolved • European Currency Reform Initiatives,1969 – 1978 • European leaders meeting at The Hague in December 1969 initiated the drive toward European monetary unification. The reason that EU countries seek closer coordination of monetary policies and greater exchange rate stability is:

4. How the European Single Currency Evolved 1. To enhance Europe’s role in the world monetary system.

5. 2. To turn in the European Union into a truly unified market. The key that Europe has come so far in both market and monetary unification lies in the continent’s war-torn history. After 1945, many European leaders agreed that economic cooperation and integration among the former belligerents would be the best guarantee against a repetition of the twentieth century’s two devastating wars.

6. How the European Single Currency Evolved • The European Monetary System The eight original participants in the EMS’s exchange rate mechanism began operating a formal network of mutually pegged exchange rates in March 1979.

7. Through a mixture of policy cooperation and realignment , the EMS fixed exchange rate club even grew until the start of the protracted European currency crisis happened in Sep. 1992. The EMS’s operation was aided by several safety valves that initially helped reduce the frequency of such crises. By Aug.1993, the EMS was forced to retreat to very wide bands, which I kept in force until the introduction of the euro in 1999.

8. How the European Single Currency Evolved • German Monetary Dominance and the Credibility Theory of the EMS The Credibility Theory of the EMS is by fixing their exchange rates against the DM, the other EMS countries in effect imported the German Bundesbank’s credibility as an inflation fighter and thus discouraged the development of inflationary pressures at home.

9. The German Bundesbank gained its low-inflation reputation because the law establishing the Bundesbank singled out the defense of the DM’s real value as the central bank’s primary goal. Consistent with this goal, the bank’s governing council has powers and membership rules that make it unusually independent of pressures from the politicians.

10. How the European Single Currency Evolved • The EU “1992” Initiative The process of market unification that began when the original EU members formed their customs union in 1957 was still incomplete 30 years later. In June 1985 the EU’s executive body issued a White Paper containing 300 proposals for “Completing the Internal Market” by the end of 1992.

11. How the European Single Currency Evolved In the Single European Act of 1986, EU members took the crucial political steps to translate the White Paper’s 1992 into reality. By now most of 1992’s market integration measures have been implemented.

12. How the European Single Currency Evolved • European Economic and Monetary Union On December 10,1991, the leaders of the EU countries met at the ancient Dutch city of Maastricht and agreed to propose for national ratification far-reaching amendments to the Treaty of Rome. These amendments were meant to place the EU squarely on the road to EMU. By 1993, all twelve countries then belonging to the EU had ratified the Maastricht Treaty.

13. The Euro and Economic Policy in the Euro Zone • The Maastricht Convergence Criteria and the Stability and Growth Pact The criteria should be satisfied to be member of EMU. A supplementary Stability and Growth Pact (SGP) negotiated by European leaders in 1997.

14. The Euro and Economic Policy in the Euro Zone • The European System of Central Banks The ESCB consist of the ECB in Frankfurt plus the twelve national central banks. Decisions of the ESCB are made by votes of the governing council of the ECB.

15. The Euro and Economic Policy in the Euro Zone The ESCB operates above and beyond the reach of any single national government. Notwithstanding its high degree of statutory independence, the ESCB is dependent on politicians in at least two respects.

16. The Euro and Economic Policy in the Euro Zone • The Revised Exchange Rate Mechanism A revised exchange rate mechanism referred to as ERM 2 defines broad exchange rate zones against the euro and specifies reciprocal intervention arrangements to support these target zones.

17. The Theory of Optimum Currency Areas The theory of optimum currency areas predicts that fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements.

18. The Theory of Optimum Currency Areas • Economic Integration and the Benefits of a Fixed Exchange Rate Area:The GG schedule • Economic Integration and the Costs of a Fixed Exchange Rate Area:The LL schedule • The Decision to Join a Currency Area: Putting the GG and LL Schedules Together • What Is an Optimum Currency Area?

19. Economic Integration and the Benefits of a Fixed Exchange Rate Area:The GG schedule The monetary efficiency gain from joining the fixed exchange rate system equals the joiners’s saving from avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float.

20. The GG Schedule Monetary efficiency gain for the joining country GG Degree of economic integration between the joining country and the exchange rate areas

21. The GG Schedule The upward sloping GG schedule shows that a country’s monetary efficiency gain from joining a fixed exchange rate area rises as the country’s economic integration with the area rises.

22. Economic Integration and the Benefits of a Fixed Exchange Rate Area:The GG schedule Our conclusion is that a high degree of economic integration between a country and a fixed exchange rate area magnifies the monetary efficiency gain the country reaps when it fixes its exchange rate against the area’s currencies.The more extensive are cross-border trade and factor movements, the greater is the gain from a fixed cross-border exchange rate.

23. Economic Integration and the Costs of a Fixed Exchange Rate Area:The LL schedule The economic stability loss from joining the fixed exchange rate system equals the joiners’s extra instability caused by the fixed exchange rate.

24. The LL Schedule Economic stability loss for the joining country LL Degree of economic integration between the joining country and the exchange rate areas

25. The LL Schedule The downward sloping LL schedule shows that a country’s economic stability loss from joining a fixed exchange rate area falls as the country’s economic integration with the area rises.

26. Economic Integration and the Costs of a Fixed Exchange Rate Area:The LL schedule We conclude that a high degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances.

27. The Decision to Join a Currency Area: Putting the GG and LL Schedules Together Deciding When to Peg the Exchange Rate Gains and losses for the joining country GG 1 Losses exceeds gains gains exceeds losses LL Degree of economic integration between the joining country and the exchange rate areas a

28. Economic Integration and the Costs of a Fixed Exchange Rate Area:The LL schedule The intersection of GG and LL at point 1 determines a critical level of economic integration a between a fixed exchange rate area and a country considering whether to join. At any level of integration above a ,the decision to join yields positive net economic benefits to the joining country.

29. The Decision to Join a Currency Area: Putting the GG and LL Schedules Together An Increase in Output Market Variability Gains and losses for the joining country GG 2 1 LL´ LL a ß Degree of economic integration between the joining country and the exchange rate areas

30. A rise in the size and frequency of country-specific disturbances to the joining country’s produce markets shifts the LL schedule upward from LL to LL´ because for a given level of economic integration with the fixed exchange rate area the country’s economic stability loss from pegging its exchange rate rises. The shift in LL raises the critical level of economic integration at which the exchange rate area is joined to ß.

31. What Is an Optimum Currency Area? Optimum currency areas are groups of regions with economies closely linked by trade in goods and services and by factor mobility. This result follows our finding that a fixed exchange rate area will best serve the economic interests of each of its members if the degree of output and factor trade among the included economies is high.

32. The Future of EMU 1. Europe is not an optimum currency area. 2. A related potential problem is that the single currency project has taken union to a level far beyond what the EU has been able (or willing) to do in the area of political union. 3. In most of the larger EU countries,labor markets remain highly unionized and subject to high government employment taxes and other regulations that impede labor mobility between industries and regions.

33. The Future of EMU 4. Constraints on national fiscal policy due to the Stability and Growth Pact (SGP) are likely to be especially painful due to the absence of substantial fiscal federalism within the EU. 5. The EU is considering a large-scale expansion of its membership into eastern Europe and the Mediterranean.

34. Question

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