CHAPTER 9 Optimum Currency Areas and the European Experience

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CHAPTER 9Optimum Currency Areas and the European
Experience
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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

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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

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How the European Single Currency Evolved

• 1. To enhance Europes role in the world
  monetary system.

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• 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
  continents 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 centurys two devastating wars.

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How the European Single Currency Evolved

• The European Monetary System
• The eight original participants in the EMSs
  exchange rate mechanism began operating a formal
  network of mutually pegged exchange rates in
  March 1979.

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• 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 EMSs 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.

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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
  Bundesbanks credibility as an inflation fighter
  and thus discouraged the development of
  inflationary pressures at home.

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

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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 EUs executive body
  issued a White Paper containing 300 proposals for
  Completing the Internal Market by the end of
  1992.

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How the European Single Currency Evolved

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

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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.

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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.

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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.

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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.

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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.

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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.

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The Theory of Optimum Currency Areas

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

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Economic Integration and the Benefits of a Fixed
Exchange Rate AreaThe GG schedule

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

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

• The upward sloping GG schedule shows that a
  countrys monetary efficiency gain from joining a
  fixed exchange rate area rises as the countrys
  economic integration with the area rises.

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Economic Integration and the Benefits of a Fixed
Exchange Rate AreaThe 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 areas
currencies.The more extensive are cross-border
trade and factor movements, the greater is the
gain from a fixed cross-border exchange rate.
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Economic Integration and the Costs of a Fixed
Exchange Rate AreaThe LL schedule

• The economic stability loss from joining the
• fixed exchange rate system equals the
  joinerss extra instability caused by the fixed
  exchange rate.

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

• The downward sloping LL schedule shows that a
  countrys economic stability loss from joining a
  fixed exchange rate area falls as the countrys
  economic integration with the area rises.

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Economic Integration and the Costs of a Fixed
Exchange Rate AreaThe 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.
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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
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Economic Integration and the Costs of a Fixed
Exchange Rate AreaThe 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.

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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
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• A rise in the size and frequency of
  country-specific disturbances to the joining
  countrys 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 countrys 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.

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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.
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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.

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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.

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Question
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• Thanks