The Single European Currency

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1 The Single European Currency A2 Economics Key Issues The essentials of Euro Area membership Convergence criteria Optimal currency area theory Recent macro performance of the Euro Area Single currency membership and external shocks The crisis for some Euro Area members 1

2 Basic history of the Euro Project 1991: Maastricht Treaty pathway for Euro 1999: Euro starts life as a currency : Original members of system lock their currencies for two years 2002: Notes and coins come into circulation 2007: Slovenia becomes first of the new member states to enter the currency union : Three new nations Slovakia, Cyprus and Malta the Euro Area extends to 16 nations : Major stresses in the Euro as a fiscal crisis engulfs a number of member nations The Euro Zone in Baffling Pigs Belgium Austria France Finland Luxembourg Italy Netherlands Germany Portugal Ireland Greece Spain 2

3 The Euro Zone in Members Belgium Austria France Finland Luxembourg Italy Netherlands Germany Slovenia Slovakia Cyprus Malta Portugal Ireland Greece Spain UK, Denmark and Sweden are all outside of the Euro Euro Essentials Monetary union is a deepening of economic integration between participating countries A single currency requires a common interest rate for the Euro Zone i.e. a common monetary policy Countries have locked their currencies together forever and adopted one currency as a medium of exchange Euro as a currency floats against US dollar and sterling Member nations are also required (in principle) to keep e be at o s a e a so equ ed ( p c p e) to eep control of government borrowing i.e. They are not allowed to run large budget deficits > 3% of their GDP (in normal times) 3

4 Britain & the Euro The Current Position Britain is outside of the Euro Zone It has an opt out from the single currency The European Central Bank (ECB) ECB sets policy interest rates for the sixteen participating nations ECB objective is price stability defined as CPI inflation of 2% or below Countries joining the Euro must meet the convergence criteria 4

5 Convergence Criteria Inflation: Average inflation over previous year must not exceed by more than1.5% that of the three lowest inflation countries Government Finances Budget deficit must not exceed 3% of GDP Gross government debt must not exceed 60% of GDP Interest Rates: Average yield on govt bonds must not exceed by more than 2% bond yields of three lowest inflation countries Exchange Rate Stability: Currency must have adhered to fluctuation margins of the ERM in two previous years without severe tension Euro Area and UK Policy Interest Rates Percent 5

6 A2 Economics Optimal Currency Areas (OCA) Is the Euro Zone an optimal currency area? Is the Euro an Optimal Currency Zone? An optimal currency zone occurs when: (1) Countries have achieved real convergence (2) They respond in similar ways to external economic shocks or policy changes (3) They have sufficient flexibility in both their product markets and labour markets to deal with these shocks High geographical mobility of labour High occupational mobility of labour Wage and price flexibility in factor markets (4) Countries are prepared to use fiscal transfers to even out some of the regional economic imbalances within the European currency union 6

7 Optimal Currency Zones (2) The Euro Zone is not an optimal currency zone! The core group of EU countries are broadly similar (Germany + France + Netherlands) Peripheral countries have big structural differences e.g. Ireland, Greece, Portugal and Spain Response to interest rate changes varies across countries And there are barriers to the mobility of labour The Euro Area is a diverse group of countries and this makes a one-size-fits-all monetary policy hugely difficult Less of a problem during benign economic conditions of the late 1990s and first half of the last decade But recent economic and financial turmoil has exposed weaknesses in the currency union Optimal Currency Zones Highly Flexible Monetary Union Works Labour Market Flexibility Inflexible High risk currency union Divergent Real Economic Convergence Convergent 7

8 A2 Economics The Case for Entry into the Euro Microeconomic Benefits of Entry (1) Potential Gains for consumers Gains from price transparency Reduction in the transactions costs of travelling within Europe (e.g. costs of currency exchange) Cheaper mortgages if interest rates Cheaper mortgages if interest rates are lower 8

9 Microeconomic Benefits of UK Entry (2) Possible gains for businesses Invoicing with just one currency Lower transactions costs when trading Stable currency and low inflation might allow businesses to fund their capital investment at lower real interest rates The Case for Staying Outside A2 Economics 9

10 Microeconomic Disadvantages (1) Changeover Costs from joining the Euro: Menu Costs (vending machines, catalogues, franking machines, postage Customer confusion (imperfect information) (2) Higher prices Potential loss of consumer welfare if suppliers increase prices when converting from sterling to euro (3) Lost instruments of policy adjustment Problems of a one-size fits all policy rate Retaining the option of making an exchange rate adjustment is useful Recent performance of the Euro Area 10

11 Comparing growth rates UK & Euro Area Percent Germany - the largest country with the Euro - a driver of policy decisions? Percent 11

12 Convergent Economic Cycles? 2000=100 Low real interest rates stimulated an unsustainable boom in some countries 12

13 Ireland boomed but over-heated A similar story in Spain now unemployment soars as recession bites Percent 13

14 One currency but different inflation rates 1996=100 And diverging unit labour costs which affects competitiveness in Euro Area Index 14

15 UK and Euro Area Inflation Compared Percent What about unemployment rates? Per cent of the labour force 15

16 Unemployment in Spain and Ireland Percent Some EU states are not ready to join the Euro E.g. interest rates still Poles apart Percent 16

17 Some countries have pegged their currency to the Euro EUR/LVL EUR/EEK Fiscal Crisis: A Growing Debt Problem PERCENT 17

18 The Euro floats against the US Dollar USD/EUR And against UK sterling EUR/GBP 18

19 Challenges facing the Euro Zone Stresses and challenges facing Euro Area 1. Little common fiscal policy Big differences in size of fiscal deficits and debt levels Fiscal stability pact has effectively collapsed Growing risk of one or more Euro Area countries defaulting on some of their debts Will Euro Area nations bail out fellow members? Years of fiscal austerity for some nations will create deep economic and social pressures 2. Doubts about the likely strength of recovery Unemployment high and rising Rising cost-push inflation could lead to higher interest rates and choke off confidence as recovery starts 19

20 Longer-term challenges Growth and employment creation in the Euro Area has not been noticeably higher than in countries outside the currency union crisis has highlighted the problems of setting a common interest rate for 16 nations Larger economic imbalances within the 16 nation currency union over wage levels, trade balances and productivity will also need to be addressed if the Euro Zone is to avoid future crises Several weaker countries have become uncompetitive inside the Euro and this requires painful corrective policies which will be unpopular 20

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