Monetary Union DEFINITION?

5 MONETARY UNIONS WORLD WIDE.

Monetary Union

Dollarisation

Monetary Union Have a Fixed Exchange Rate between member countries Common Monetary Policy

General Problems4 main underlying causes of exchange rate movements are divergences in Interest Rates Growth Rates Inflation Rates Current Account BoP

As there is greater harmonisation of economic policies (discussed at G 8 meetings) there is less divergence between countries in these areas.

But countries have to agree to work for the common good. If US is worried about the size of its budget deficit it may not wish to respond to world demands for a stimulus to aggregate demand to pull the world out of a recession.Also Speculators seeing differences between countries are likely to exaggerate these differences by their actions, causing large changes in exchange rates as they cause shifts in the D and S for a country’s currency.

Monetary Union

Difficulties in achieving international policy harmonisation: Countries’ budget deficits and national debt may differ substantially as a proportion of their national income. Countries have different rates of productivity increase, product development, investment and market penetration. A lack of convergence here means that the growth in exports relative to imports will differ for any given level of inflation or growth. Countries may be very unwilling to change their domestic policies to fall in line with other countries. They may prefer the other countries to fall in line with them!

Monetary Union Steps towards a Monetary Union – Europe

One way of achieving greater currency stability is for countries to group together into blocs, and to peg their exchange rates to each other, while floating against the rest of the world. Advantages include:-Encouraging trade between members of the block.- the combined reserves of all countries in the bloc can be used to prevent excessive fluctuations of the bloc’s currencies with the rest of the world.The Exchange rate mechanism (ERM) of the European Monetary System was an example of such an arrangement. 1979 – aim to create currency stability, monetary co-operation and the convergence of economic policies in EC countries. It involved participants pegging their exchange rate to each other within bands, and jointly floating with the rest of the world.UK joined in 1990 but left in 1992. Replaced by single currency in 1999.

Monetary Union

Establishing the ERM Each currency was given a central exchange rate with each of the other ERM currencies in a grid. Fluctuations were allowed +/- 2%. The central rates could be adjusted by agreement – adjustable peg system. If a currency reached the upper or lower limit against any other ERM currency, intervention would take place to maintain the currency within the band. Central banks in the ERM would sell the strong currency and buy the weak one. Another way = weak currency countries raising interest rates and the strong currency countries lowering them.

Monetary Union

ERM in PracticeIn this system of pegged exchange rates, countries could harmonise their policies to avoid excessive currency misalignments and the need for large devaluations or revaluations.There should be a convergence of their economies however – should be at a similar point on the business cycle and have similar inflation and interest rates.

Monetary Union

ERM IN 1980S French and Italian inflation rates were persistently higher than German rates – thee had to be several realignments. As the 1980s progressed thee was a growing convergence of members’ internal policies and less realignments needed to occur. By 1990 the ERM it was seen as a success –created a zone of currency stability in a world of highly unstable exchange rates – was providing the necessary environment for the establishment of a truly common market by the end of 1992.

Monetary Union Crisis in the ERM

UK joined during this confident period.

But Germany reunified – Germany running a large budget deficit. Bundesbank – maintain high interest rates to keep inflation in check. At same time UK was experiencing a massive current account deficit – we had signed on to the ERM at perhaps too high an exchange rate. UK felt it had to raise interest rates in order to protect the pound, though the economy was sliding into recession The French franc and Italian lira were also perceived to be overvalued. At the same time US sliding into a recession – cut its interest rates – large outflow of capital from USA. With high German interest rates much went to Germany.

This pushed up the value of the Mark and with it the other ERM currencies.In September 1992 first Italy and then the UK were forced to leave the ERM – the pound and the lira were floated.

Monetary Union

The Road to EMU If there was to be a move from ERM to monetary union with a single currency then convergence was essential. not only between economic indicators such as growth, interest rates, inflation rates and levels of government debt BUT also between the policies of their governments and the structure of their economies and institutions. May 1998 11 of 15 EU countries decided to proceed to EMU – the Euro to come into effect in Jan 1999

Monetary Union

The Road to EMU In Jan 1999 only EU countries not joining were UK, Sweden and Denmark. Denmark stayed in ERM2 – Krone pegged to the euro within a band. Sweden and UK have opt outs Enlargement – countries had to join ERM2 for at least two years.

Monetary Union

EMU Convergence Criteria

Inflation

Interest Rates

Budget Deficit

National Debt

Exchange Rates (ERM for 2 years)

Monetary Union

ADVANTAGES DISADVANTAGES

Reduce Ex Rate Costs

Greater Price Transparency

More trade with partner countries

Inward investment

Macroeconomic Management

Greater Economic Integration

Transition Costs

Loss of Policy Independence

Structural Issues (one size fits all)

Loss of Political Sovereignty

Monetary Union Problemse.g. if Spain has higher rate of inflation than rest of Eurozone – pre EMU it would allow currency to depreciate – after EMU just becomes a depressed region of Europe.

Could be argued that Zone needs a fully developed fiscal policy which will divert funds into investment in such regions more than is currently happening.

Even if countries continue to harmonise policies, becoming linked in Buziness Cycles etc External shocks (price of oil) might still effect them in different ways.