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Existing Currency Unions (Cont.)

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Existing Currency Unions (Cont.) Preview • Definition and Examples • Case Study: The Euro-zone PP542 • The European Monetary System • Policies of the EU and the EMS Currency Unions • Theory of optimal currency areas • Is the EU an optimal currency area? • Other considerations of a economic and monetary union K. Dominguez, Winter 2010 2 Currency union Existing currency unions • The CFA franc BEAC is used by Cameroon, the Central African Republic, Chad, the Republic of the • a currency union is a fixed exchange Congo, Equatorial Guinea and Gabon and is issued by the Communauté Économique et Monétaire de rate regime in which two or more l'Afrique Centrale (CEMAC), i.e. the Economic and countries agree to share a single Monetary Community of Central Africa. • The CFA franc BCEAO is used by Benin, Burkina currency (or a common currency) Faso, Côte d'Ivoire, Guinea-Bissau, Mali, Niger, among them. Senegal, and Togo and is issued by the Union Économique et Monétaire Ouest Africaine (UEMOA), i.e. the West African Economic and Monetary Union. • The CFP franc is used by French Polynesia, New Caledonia, and Wallis and Futuna and is issued by the Institut d'émission d'outre-mer (IEOM), i.e. the Overseas Issuing Institute. K. Dominguez, Winter 2010 3 K. Dominguez, Winter 2010 4 Existing currency unions (cont.) Existing currency unions (cont.) • The East Caribbean dollar is used by • The euro is used by sixteen European Union member states: Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Anguilla, Antigua and Barbuda, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain and is also used in Monaco, San Dominica, Grenada, Montserrat, Saint Marino, and the Vatican City which are licensed to issue and use Kitts and Nevis, Saint Lucia, and Saint the euro. • Agreements were also concluded for two overseas territories of Vincent and the Grenadines and is France. Saint-Pierre-et-Miquelon off the coast of Canada, and Mayotte in the Indian Ocean are outside the EMU but have been issued by the Eastern Caribbean allowed to use the euro as their currency. They are, however, not allowed to mint any of their own coins. Currency Union of the Organization of • Finally, four other countries and a subnational entity use the euro but are not licensed to issue any euro coins or notes, Akrotiri and Eastern Caribbean States (OECS). Dhekelia, Andorra, Montenegro and Kosovo. • The euro is issued by the European Central Bank. K. Dominguez, Winter 2010 5 K. Dominguez, Winter 2010 6 1 CASE STUDY: The Euro-zone currency De facto currency unions union • The South African rand is legal tender in • The Euro-zone currency union is South Africa, Swaziland, Lesotho, and Namibia through the Common Monetary Area. unusual in that member countries created a new currency (the Euro) rather • The Swiss franc is legal tender in Switzerland and Liechtenstein. than agreeing to share a pre -existing • The United States dollar is used by the United currency. States and its possessions, Palau, • The Euro-zone also differs from other Micronesia, the Marshall Islands, Panama, Ecuador, El Salvador, East Timor, the British currency unions in that member Virgin Islands and the Turks and Caicos countries have unified more broadly Islands. both economically and politically. K. Dominguez, Winter 2010 7 K. Dominguez, Winter 2010 8 What Is the EU? What Is the EMS? • The European Union is a system of international • The European Monetary System was institutions, the first of which originated in 1957, which originally a system of fixed exchange rates now represents 27 European countries through the: implemented in 1979 through an exchange European Parliament: elected by citizens of member rate mechanism (ERM). countries Council of the European Union: appointed by governments • The EMS has since developed into an of the member countries economic and monetary union (EMU), European Commission: executive body a more extensive system of coordinated Court of Justice: interprets EU law economic and monetary policies. European Central Bank, which conducts monetary policy, through a system of member country banks called the The EMS has replaced the exchange rate European System of Central Banks mechanism for most members with a common currency under the economic and monetary union. K. Dominguez, Winter 2010 9 K. Dominguez, Winter 2010 10 Membership of the Membership of the EU Economic and Monetary Union • To be part of the economic and monetary • To be a member of the EU, a country must, union, EMS members must among other things, 1. first adhere to the ERM: exchange rates were 1. have low barriers that limit trade and flows of fixed in specified bands around a target exchange financial assets rate, 2. adopt common rules for emigration and 2. next follow restrained fiscal and monetary policies immigration to ease the movement of people as determined by Council of the European Union 3. establish common workplace safety and and the European Central Bank, consumer protection rules 3. finally replace the national currency with the euro, 4. establish certain political and legal institutions whose circulation is determined by the European that are consistent with the EU’s definition of System of Central Banks. liberal democracy. K. Dominguez, Winter 2010 11 K. Dominguez, Winter 2010 12 2 Current Members of the Euro Zone K. Dominguez, Winter 2010 13 K. Dominguez, Winter 2010 14 Why the EU? Why the Euro (EMU)? EU members adopted the euro for principally 4 reasons: • Countries that established the EU and EMS had several goals 1. Unified market: the belief that greater market integration and economic growth would occur. 1. To enhance Europe’s power in international affairs: as a union of countries, the EU could represent more economic 2. Political stability: the belief that a common currency would and political power in the world. make political interests more uniform. 2. To make Europe a unified market: a large market with free 3. The belief that German influence under the EMS would trade, free flows of financial assets and free migration of be moderated under a European System of Central Banks. people—in addition to fixed exchange rates or a common 4. Eliminate the possibility of devaluations/revaluations: currency—were believed to foster economic growth and with free flows of financial assets, capital flight and economic well being. speculation could occur in an EMS with separate 3. To make Europe politically stable and peaceful. currencies, but would be more difficult with a single currency. K. Dominguez, Winter 2010 15 K. Dominguez, Winter 2010 16 The EMS from 1979–1998 The EMS from 1979–1998 (cont.) • From 1979–1993, the EMS defined the exchange To prevent speculation, rate mechanism to allow most currencies to fluctuate +/- 2.25% around target exchange rates. • early in the EMS some exchange controls were also enforced to limit trading of currencies. • The exchanggge rate mechanism allowed larger fluctuations (+/- 6%) for currencies of Portugal, Spain, But from 1987–1990 these controls were lifted in order to make the EU a common market for financial assets. Britain (until 1992) and Italy (until 1990). These countries wanted greater flexibility with monetary • a credit system was also developed among EMS policy. members to lend to countries that needed assets and The wider bands were also intended to prevent speculation currencies that were in high demand in the foreign caused by differing monetary and fiscal policies. exchange markets. K. Dominguez, Winter 2010 17 K. Dominguez, Winter 2010 18 3 The EMS from 1979–1998 (cont.) The EMS from 1979–1998 (cont.) • • But because of differences in monetary and fiscal But eventually, each EMS member adopted policies across the EMS, markets participants began similarly restrained fiscal and monetary buying German assets (because of high German policies, and the inflation rates in the EMS interest rates) and selling other EMS assets. eventually converged (and speculation slowed or std)topped). • As a result, Britain left the EMS in 1992 and allowed the pound to float against other European currencies. In effect, EMS members were following the restrained monetary policies of Germany, which • As a result, exchange rate mechanism was redefined has traditionally had low inflation. in 1993 to allow for bands of +/-15% of the target Under the EMS exchange rate mechanism of value in order devalue many currencies relative to fixed bands, Germany was “exporting” its the deutschemark. monetary policy. K. Dominguez, Winter 2010 19 K. Dominguez, Winter 2010 20 Inflation Convergence for Six Original Euro-zone long-term government EMS Members, 1978–2006 bond yields,1990-2006 18 16 AUS BLG FIN FRA 14 GRE GER IRE ITA 12 NTH PRT SPA 10 8 percent (%) 6 4 2 0 1/1/1990 7/1/1990 1/1/1991 7/1/1991 1/1/1992 7/1/1992 1/1/1993 7/1/1993 1/1/1994 7/1/1994 1/1/1995 7/1/1995 1/1/1996 7/1/1996 1/1/1997 7/1/1997 1/1/1998 7/1/1998 1/1/1999 7/1/1999 1/1/2000 7/1/2000 1/1/2001 7/1/2001 1/1/2002 7/1/2002 1/1/2003 7/1/2003 1/1/2004 7/1/2004 1/1/2005 7/1/2005 1/1/2006 Source: CPI inflation rates from International Monetary Fund, International Financial Statistics. K. Dominguez, Winter 2010 21 K. Dominguez, Winter 2010 Policies of the EU and EMS Policies of the EU and EMS (cont.) • Single European Act of 1986 recommended that • The Maastricht Treaty requires that members which many barriers to trade, financial assets flows and want to enter the economic and monetary union immigration be removed by December 1992. 1. attain exchange rate stability defined by the ERM It also allowed EU ppyolicy to be app roved with less than before adopting the euro.
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