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Home , Currency union, De facto currency, Montenegro and the euro

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• Definition and Examples • Case Study: The -zone PP542 • The • Policies of the EU and the EMS Unions • Theory of optimal currency areas • Is the EU an optimal currency area? • Other considerations of a economic and monetary union

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Currency union Existing currency unions

• The CFA franc BEAC is used by , the , , the Republic of the • a currency union is a fixed exchange Congo, and 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 , Burkina currency (or a common currency) Faso, Côte d'Ivoire, Guinea-Bissau, , , among them. , and 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 , , and and is issued by the Institut d'émission d'outre-mer (IEOM), i.e. the Overseas Issuing Institute.

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Existing currency unions (cont.) Existing currency unions (cont.) • The East Caribbean dollar is used by • The euro is used by sixteen member states: , , , , , , , , , Ireland, , , , the , , , and and is also used in , San , , , Saint Marino, and the which are licensed to issue and use Kitts and Nevis, , 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 or notes, Akrotiri and Eastern Caribbean States (OECS). Dhekelia, , and . • The euro is issued by the European .

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1 CASE STUDY: The Euro-zone currency De facto currency unions union

• The is legal tender in • The Euro-zone currency union is , Swaziland, , and through the . unusual in that member countries created a new currency (the Euro) rather • The is legal tender in and . than agreeing to share a pre -existing • The dollar is used by the United currency. States and its possessions, , • The Euro-zone also differs from other Micronesia, the , , , , , the British currency unions in that member Virgin Islands and the Turks and Caicos countries have unified more broadly Islands. both economically and politically.

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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),  : executive body a more extensive system of coordinated  Court of Justice: interprets EU law economic and monetary policies.  , which conducts , through a system of member country banks called the  The EMS has replaced the European System of Central Banks mechanism for most members with a common currency under the economic and monetary union.

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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 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.

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2 Current Members of the Euro Zone

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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 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. , but would be more difficult with a single currency.

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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.

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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 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.

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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.

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Policies of the EU and EMS Policies of the EU and EMS (cont.)

• Single European Act of 1986 recommended that • The 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 a pproved with less than before adopting the euro. unanimous consent among members. 2. attain price stability: a maximum inflation rate of • Maastricht Treaty, proposed in 1991, required the 3 1.5% above the average of the three lowest national provisions to transform the EMS into a economic and inflation rates among EU members. monetary union.  It also required standardizing regulations and centralizing 3. maintain a restrictive : foreign and defense policies among EU countries.  a maximum ratio of government deficit to GDP of 3%.  Some EU/EMS members have not ratified all of the clauses.  a maximum ratio of to GDP of 60%.

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4 Policies of the EU and EMS (cont.) Violations of the Maastricht Criteria

CPI Inflation (%) 1/ 10-Year Interest Rates (%) 2/ Budget Deficit (% GDP) 3/ Public Debt (% GDP) 3/

• The Maastricht Treaty requires that members which Threshold value 2.5 3.5 2.8 8.1 6.9 5.3 -3.0 -3.0 -3.0 60.0 60.0 60.0 want to remain in the economic and monetary union 1995 2000 2005 1995 2000 2005 1995 2000 2005 1995 2000 2005 Austria 1.8 2.6 1.5 6.4 5.2 3.3 -5.3 -1.7 -1.8 69.2 67.0 64 1. maintain a restrictive fiscal policy: Belgium 1.5 2.5 3.0 6.7 5.3 3.3 -4.4 0.2 0.0 133.9 109.2 93.5 Finland 0.2 3.4 1.4 7.1 5.1 3.2 -3.9 7.1 1.3 57.1 45.5 42  a maximum ra tio o f government td defi fiittcit to GDP of f3% 3%. France 2.1 1.6 1.4 6.6 5.0 3.3 -5.5 -1.4 -3.5 54.6 57.1 66 Germany 1.5 2.1 1.2 6.0 5.5 3.3 -3.3 1.3 -4.0 54.1 60.6 68

 a maximum ratio of government debt to GDP of 60%. Greece 7.6 3.8 3.1 … 4.9 … -10.2 -4.2 -4.2 108.7 114.0 108.6

Ireland … 5.7 2.5 7.3 5.0 3.3 -2.1 4.4 0.5 84.0 41.5 28.1

 financial penalties are imposed on countries with Italy 5.4 2.7 2.0 10.9 5.3 3.5 -7.6 -0.7 -4.4 124.2 111.1 106.5

“excessive” deficits or debt. Luxembourg 1.2 3.4 3.0 … … … … 5.6 -2.3 … 5.5 5.0

Netherlands 1.7 2.9 2.5 6.0 5.0 3.3 -4.0 2.1 -1.2 73.8 56.1 52.5 • The Stability and Growth Pact, negotiated in 1997, Portugal 3.3 3.9 2.5 9.8 5.2 3.4 -5.5 -2.9 -6.2 64.3 53.3 65.8 also allows for financial penalties on countries with Spain 4.2 3.9 3.9 9.7 5.2 3.3 -6.7 -0.9 -0.1 63.9 61.1 47 “excessive” deficits or debt.

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Debt as a % of GDP, Policies of the EU and EMS (cont.) 1992-2010

• The euro was adopted in 1999, and the previous exchange rate mechanism became obsolete. • But a new exchange rate mechanism—ERM 2—was established between the economic and monetary union and outside countries.  It allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union in the future to maintain stable exchange rates before doing so.  It allowed EU members outside of the economic and monetary union to maintain fixed exchange rates if desired.

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USD-Euro, 1999-2010 The Global Role of the Euro

• In the early, heady days after the signing of the Maastricht Treaty, there were suggestions that once monetary union was solidly in place, the euro might rival or even surpass the dollar as the world’s international . • To date, there is little evidence that the global role of the dollar has been usurped.

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5 Currency Usage Theory of Optimum Currency Areas

50 Currency Distrbution in Forex Market • The theory of optimum currency areas USD 45 argues that the optimal area for a system of 40 fixed exchange rates, or a common currency, 35 is one that is highly economically integrated. 30

25  means free flows of Percent (%) 20 • goods and services (trade) EUR

15 JPY • financial capital (assets) and physical capital

10 • UKP workers/labor (immigration and emigration) 5 • The theory was developed by Robert Mundell 0 1989 1992 1995 1998 2001 2004 2007 in 1961. Euro introduced

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Theory of Optimum Currency Areas (cont.) Theory of Optimum Currency Areas (cont.)

• Fixed exchange rates have costs and benefits • The monetary efficiency gain of joining a fixed exchange rate system depends on the amount of for countries deciding whether to adhere to economic integration. them. • Joining fixed exchange rate system would be • BfitffidhBenefits of fixed exchange ra tes are thtthat beneficial for a country if: they avoid the uncertainty and international 1. trade is extensive between it and member countries, because transaction costs would be reduced greatly. transaction costs that floating exchange 2. financial assets flow freely between it and member rates involve. countries, because the uncertainty about rates of return would be reduced greatly. • Define this gain that would occur if a country 3. people migrate freely between it and member countries, joined a fixed exchange rate system as the because the uncertainty about the purchasing power of monetary efficiency gain. wages would be reduced greatly.

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Theory of Optimum Currency Areas (cont.) The GG Schedule

• In general, as the degree of economic integration increases, the monetary efficiency gain increases.

• The GG schedule shows monetary efficiency gain as a function of the degree of economic integration.

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6 Theory of Optimum Currency Areas (cont.) Theory of Optimum Currency Areas (cont.)

When considering the monetary efficiency gain, • Economic integration also allows prices to • we have assumed that the members of the fixed converge between members of a fixed exchange rate system would maintain stable prices. exchange rate system and a potential  But when variable inflation exists among member countries, member. then joining the system would not reduce uncertainty (as much).  The law of one price is expected to hold better • we have assumed that a new member would be fully when markets are integrated. committed to a fixed exchange rate system.  But if a new member is likely to leave the fixed exchange rate system, then joining the system would not reduce uncertainty (as much).

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Theory of Optimum Currency Areas (cont.) Theory of Optimum Currency Areas (cont.)

• Costs of fixed exchange rates are that they • The economic stability loss of joining a fixed exchange rate system also depends on the amount require the loss of monetary policy for of economic integration. stabilizing output and employment, and the • After jjgoining a fixed exchan ge rate s ystem, if the loss of automatic adjustment of exchange new member faces a fall in aggregate demand: rates to changes in aggregate demand. 1. Relative prices will tend to fall, which will lead other members to increase aggregate demand greatly if • Define this loss that would occur if a country economic integration is extensive, so that the economic joined a fixed exchange rate system as the loss is not as great. 2. Financial assets or labor will migrate to areas with higher economic stability loss. returns or wages if economic integration is extensive, so that the economic loss is not as great.

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Theory of Optimum Currency Areas (cont.) Theory of Optimum Currency Areas (cont.)

3. The loss of the automatic adjustment of flexible exchange • In general, as the degree of economic rates is not as great if goods and services markets are integrated. Why? integration increases, the economic stability loss decreases. • Consider what would have happened if the country did not join the fixed exchange rate system: • The LL schedule shows economic stability • the automatic adjustment would have caused a depreciation of loss as a function of the degree of economic the domestic currency and an appreciation of foreign currencies, which would have caused an increase in many integration. prices for domestic consumers when goods and services markets are integrated.

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7 The LL Schedule Theory of Optimum Currency Areas (cont.)

• At some critical point measuring the degree of integration, the monetary efficiency gain will exceed the economic stability loss for a member considering whether to join a fixed exchange rate system.

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Deciding When to Peg the Exchange Rate Theory of Optimum Currency Areas (cont.)

• There could be an event that causes the frequency or magnitude of changes in aggregate demand to increase for a country. • If so, th e economi c st abilit y loss wou ld be greater for every measure of economic integration between a new member and members of a fixed exchange rate system. • How would this affect the critical point where the monetary efficiency gain equals economic stability loss?

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An Increase in Output Market Is the EU an ? Variability

• If the EU/EMS/economic and monetary union can be expected to benefit members, we expect that its members have a high degree of economic integration:  large trade volumes as a fraction of GDP  a large amount of foreign financial investment and foreign direct investment relative to total investment  a large amount of migration across borders as a fraction of total labor force

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8 Is the EU an Intra-EU Trade as a Percent of EU Optimum Currency Area? (cont.) GDP

• Most EU members from 10% to 20% of GDP to other EU members  This compares with of less than 2% of EU GDP to the US.  But trade between regions in the US is a larger fraction of regional GDP. • Was trade restricted by regulations that were removed under the Single European Act?

Source: OECD Statistical Yearbook and Eurostat.

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Is the EU an Divergent Inflation in the Euro Zone Optimum Currency Area? (cont.)

• Deviations from the law of one price also occur in many EU markets.  If EU markets were greatly integrated, then the (djtd)ifddi(currency adjusted) prices of goods and services should be nearly the same across markets.  The price of the same BMW car varies 29.5% between British and Dutch markets.  How much does price discrimination occur?

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People Changing Region of Is the EU an Residence in the 1990s (percent of Optimum Currency Area? (cont.) total population) • There is also little evidence that regional migration is extensive in the EU. • Europe has many languages and cultures, which hinder migration and labor mobility. • Unions and regulations also impede labor movements between industries and countries.

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9 Is the EU an Is the EU an Optimum Currency Area? (cont.) Optimum Currency Area? (cont.)

• Evidence also shows that differences of US • There is evidence that financial assets were regional unemployment rates are smaller and able to move more freely within the EU after less persistent than differences of national 1992 and 1999. un em poyploym ent r aesates in th e E U, in dcadicatin gag a • Bu t capit al mo bility w ithou t la bor mo bility can lack of EU labor mobility. make the economic stability loss greater.  After a reduction of aggregate demand in a particular EU country, financial assets could be easily transferred elsewhere while labor is stuck.  The loss of financial assets could further reduce production and employment.

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Other Considerations for an EMU Other Considerations for an EMU (cont.)

• The structure of the economies in the EU’s  How an EU member responds to aggregate economic and monetary union is important for demand shocks may depend how the structure its determining how members respond to economy compares to that of fellow EU members. aggregate demand shocks.  For exampl e, th e eff ect s of a red ucti on i n  The economies of EU members are similar in the sense that there is a high volume of intra-industry aggregate demand caused a reduction in demand trade relative to the total volume. in the software industry will depend if a EU member has a large number of workers skilled in  They are different in the sense that Northern programming relative to fellow EU members. European countries have high levels of physical capital per worker and more skilled labor, compared with Southern European countries.

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Other Considerations for an EMU (cont.) Euro: Tricky Balancing Act

• The amount of transfers among the EU members may also affect how EU economies respond to aggregate demand shocks.  Fiscal payments between countries in the EU’s federal system, or fiscal federalism, may help offset the economic stability loss from joining an economic and monetary union.  But relative to inter-regional transfers in the U.S., little fiscal federalism occurs among EU members.

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10 Euro-zone Euro-zone long-term government current account balances bond yields, 2008-10

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Will the Euro survive? Greek Tragedy

• The true test of the influence of the ECB and the longevity of the euro may hinge on what happens • Over the past decade, Greece took full advantage of a strong euro and in Greece, Italy, Portugal and Spain in the next few rock-bottom interest rates to fuel a debt binge by the country's months... consumers and its government. When the global economy crumpled, the stage was set for a financial crisis. • Its trigger was Greece's admission in late 2009 that its government deficit would be 12.7 percent of its gross domestic product, not the 3.7 percent the previous government had forecast earlier. • Investors were stunned. • In early 2010, the fears grew into a full-fledged financial panic, as investors questioned whether Greece's Socialist government could push through the tough measures it has promised to reduce its budget deficit.

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Greek Tragedy The View of Financial Markets…

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