CHAPTER 20Optimum Currency

Areas and the European Experience

Optimum Currency Areas and the European Experience

How the European Single Currency EvolvedHow the European Single Currency Evolved The Euro and Economic Policy in the Euro ZoThe Euro and Economic Policy in the Euro Zo

nene The Theory of Optimum Currency AreasThe Theory of Optimum Currency Areas The Future of EMUThe Future of EMU

How the European Single Currency Evolved European Currency Reform European Currency Reform

Initiatives,1969 – 1978Initiatives,1969 – 1978

European leaders meeting at The Hague in European leaders meeting at The Hague in December 1969 initiated the drive toward December 1969 initiated the drive toward European monetary unification. The European monetary unification. The reason that EU countries seek closer reason that EU countries seek closer coordination of monetary policies and coordination of monetary policies and greater exchange rate stability is:greater exchange rate stability is:

1. To enhance Europe’s role in the world 1. To enhance Europe’s role in the world monetary system.monetary system.

How the European Single Currency Evolved

2. To turn in the European Union into a truly 2. To turn in the European Union into a truly unified market.unified market.

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

The European Monetary SystemThe European Monetary System The eight original participants in the EMS’s The eight original participants in the EMS’s

exchange rate mechanism began operating a exchange rate mechanism began operating a formal network of mutually pegged formal network of mutually pegged exchange rates in March 1979. exchange rates in March 1979.

How the European Single Currency Evolved

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

German Monetary Dominance and the German Monetary Dominance and the Credibility Theory of the EMSCredibility Theory of the EMS

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

How the European Single Currency Evolved

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

The EU “1992” InitiativeThe EU “1992” Initiative

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

How the European Single Currency Evolved

How the European Single Currency Evolved

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

European Economic and Monetary European Economic and Monetary UnionUnion

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

How the European Single Currency Evolved

The Euro and Economic Policy in the Euro Zone

The Maastricht Convergence Criteria The Maastricht Convergence Criteria and the Stability and Growth Pactand the Stability and Growth Pact

The criteria should be satisfied to be The criteria should be satisfied to be member of EMU.member of EMU.

A supplementary Stability and Growth Pact A supplementary Stability and Growth Pact (SGP) negotiated by European leaders in (SGP) negotiated by European leaders in 1997.1997.

The European System of Central The European System of Central BanksBanks

The ESCB consist of the ECB in Frankfurt The ESCB consist of the ECB in Frankfurt plus the twelve national central banks.plus the twelve national central banks.

Decisions of the ESCB are made by votes Decisions of the ESCB are made by votes of the governing council of the ECB.of the governing council of the ECB.

The Euro and Economic Policy in the Euro Zone

The Euro and Economic Policy in the Euro Zone

The ESCB operates above and beyond the The ESCB operates above and beyond the reach of any single national government.reach of any single national government.

Notwithstanding its high degree of Notwithstanding its high degree of statutory independence, the ESCB is statutory independence, the ESCB is dependent on politicians in at least two dependent on politicians in at least two respects.respects.

The Revised Exchange Rate The Revised Exchange Rate MechanismMechanism

A revised exchange rate mechanism referred A revised exchange rate mechanism referred to as ERM 2 defines broad exchange rate to as ERM 2 defines broad exchange rate zones against the euro and specifies zones against the euro and specifies reciprocal intervention arrangements to reciprocal intervention arrangements to support these target zones.support these target zones.

The Euro and Economic Policy in the Euro Zone

The Theory of Optimum Currency Areas

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

The Theory of Optimum Currency Areas Economic Integration and the Benefits of a Economic Integration and the Benefits of a

Fixed Exchange Rate Fixed Exchange Rate Area:TheArea:The GG schedule GG schedule

Economic Integration and the Costs of a FiEconomic Integration and the Costs of a Fixed Exchange Rate xed Exchange Rate Area:TheArea:The LL schedule LL schedule

The Decision to Join a Currency Area: PuttiThe Decision to Join a Currency Area: Putting the GG and LL Schedules Togetherng the GG and LL Schedules Together

What Is an Optimum Currency Area?What Is an Optimum Currency Area?

Economic Integration and the Benefits of a Fixed Exchange Rate Area:The GG schedule

The The monetary efficiency gainmonetary efficiency gain from joining from joining the fixed exchange rate system equals the the fixed exchange rate system equals the joiners’s saving from avoiding the joiners’s saving from avoiding the uncertainty, confusion, and calculation and uncertainty, confusion, and calculation and transaction costs that arise when exchange transaction costs that arise when exchange rates float. rates float.

Monetary efficiency gain for the joining country

Degree of economic integration between the joining country and the exchange rate areas

GG

The GG Schedule

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.

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.

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 The economic stability loss economic stability loss from joining the from joining the

fixed exchange rate system equals the fixed exchange rate system equals the joiners’s joiners’s extraextra instability caused by the instability caused by the fixed exchange rate.fixed exchange rate.

Degree of economic integration between the joining country and the exchange rate areas

Economic stability loss for the joining country

LL

The LL Schedule

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.

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.

Economic Integration and the Costs of a Fixed Exchange Rate Area:The LL schedule

Deciding When to Peg the Exchange Rate

Degree of economic integration between the joining country and the exchange rate areas

Gains and losses for the joining country

GG

LLa

1Losses exceeds gains

gains exceeds losses

The Decision to Join a Currency Area: Putting the GG and LL Schedules Together

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.

The Decision to Join a Currency Area: Putting the GG and LL Schedules Together

An Increase in Output Market Variability

Degree of economic integration between the joining country and the exchange rate areas

Gains and losses for the joining country GG

LL

1

a

LL´

2

ß

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.

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.

What Is an Optimum Currency Area?

The Future of EMU

1. 1. Europe is not an optimum currency area.Europe is not an optimum currency area.2. A related potential problem is that the single 2. A related potential problem is that the single

currency project has taken union to a level far currency project has taken union to a level far beyond what the EU has been able (or beyond what the EU has been able (or willing) to do in the area of political union.willing) to do in the area of political union.

3. In most of the larger EU countries,labor 3. In most of the larger EU countries,labor markets remain highly unionized and subject markets remain highly unionized and subject to high government employment taxes and to high government employment taxes and other regulations that impede labor mobility other regulations that impede labor mobility between industries and regions.between industries and regions.

The Future of EMU

4. Constraints on national fiscal policy due to 4. Constraints on national fiscal policy due to the Stability and Growth Pact (SGP) are the Stability and Growth Pact (SGP) are likely to be especially painful due to the likely to be especially painful due to the absence of substantial fiscal federalism absence of substantial fiscal federalism within the EU.within the EU.

5. The EU is considering a large-scale 5. The EU is considering a large-scale expansion of its membership into eastern expansion of its membership into eastern Europe and the Mediterranean.Europe and the Mediterranean.

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