Special Topics in Economics Special Topics in Economics Econ. 491Econ. 491

Chapter 4:Chapter 4:

Monetary Union & the European Monetary Union & the European ExperienceExperience

I. European UnionI. European UnionWhat is the EU?What is the EU? The European Union is a system of international institutions, the

first of which originated in 1957, which now represents 27 European countries through the:

European Parliament: elected by citizens of member countries

Council of the European Union: appointed by governments of the member countries

European Commission: executive body

Court of Justice: interprets EU law

European Central Bank, which conducts monetary policy, through a system of member country banks called the European System of Central Banks

Membership of the EUMembership of the EU

To be a member of the EU, a country must, To be a member of the EU, a country must, among other things, among other things,

1.1. have low barriers that limit trade and flows of have low barriers that limit trade and flows of financial capitalfinancial capital

2.2. adopt common rules for emigration and immigration adopt common rules for emigration and immigration to ease the movement of people.to ease the movement of people.

3.3. establish common workplace safety and consumer establish common workplace safety and consumer protection rulesprotection rules

4.4. establish certain political and legal institutions that are establish certain political and legal institutions that are consistent with the EU’s definition of liberal consistent with the EU’s definition of liberal democracy.democracy.

Why the EU?Why the EU?

Countries that established the EU and EMS had several goalsCountries that established the EU and EMS had several goals

1.1. To enhance Europe’sTo enhance Europe’s power in international affairs power in international affairs: as a : as a union of countries, the EU could represent more economic and union of countries, the EU could represent more economic and political power in the world.political power in the world.

2.2. To make Europe a To make Europe a unified marketunified market: a large market with free : a large market with free trade, free flows of financial capital and free migration of trade, free flows of financial capital and free migration of people—in addition to fixed exchange rates or a common people—in addition to fixed exchange rates or a common currency—were believed to foster economic growth and currency—were believed to foster economic growth and economic well being.economic well being.

3.3. To make Europe To make Europe politically stable and peacefulpolitically stable and peaceful..

II. European Monetary SystemII. European Monetary System

What is the EMS?What is the EMS?

The The European Monetary SystemEuropean Monetary System was originally a system of was originally a system of fixed exchange rates implemented in 1979 through an fixed exchange rates implemented in 1979 through an exchange rate mechanismexchange rate mechanism (ERM). (ERM).

The EMS has since developed into an The EMS has since developed into an economic and economic and monetary union monetary union (EMU), a more extensive system of (EMU), a more extensive system of coordinated economic and monetary policies.coordinated economic and monetary policies.

The EMS has replaced the exchange rate mechanism for The EMS has replaced the exchange rate mechanism for most members with a common currency under the most members with a common currency under the economic and monetary union. economic and monetary union.

Stages of the Economic & Monetary Union (EMU)Stages of the Economic & Monetary Union (EMU)

There are three Stages for EMU:There are three Stages for EMU:

First Stage:First Stage:

A First Stage A First Stage attempts to create an economic and monetary attempts to create an economic and monetary union between the members of the European Communities union between the members of the European Communities goes back to an initiative by the European Commission in goes back to an initiative by the European Commission in 19691969, which set out the need for "greater co-ordination of , which set out the need for "greater co-ordination of economic policies and monetary cooperation.economic policies and monetary cooperation.

Second Stage:Second Stage:

A Second Stage A Second Stage was during the was during the period of 1 January 1994 to 31 December 1998.

This stage includes

1- the establishment of the European Central Bank (ECB),

Stages of the Economic & Monetary Union (EMU)Stages of the Economic & Monetary Union (EMU)

2- more details such as the name of the new currency (the euro) such as the name of the new currency (the euro) as well as the duration of the transition periods are decided, and as well as the duration of the transition periods are decided, and

3- the 3- the 11 initial countries 11 initial countries that will participate in the third stage that will participate in the third stage from 1 January 1999 are selected.from 1 January 1999 are selected.

These countries include Austria Belgium, Finland, France, Austria Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain. Portugal, and Spain.

Third Stage:

A Third Stage is the period started by January 1999 and January 1999 and continuing. This is when the Euro was launched. continuing. This is when the Euro was launched.

There are There are 5 more countries 5 more countries joined the Euro in this Stage to joined the Euro in this Stage to push push number of countries to 17number of countries to 17. .

These countries include Greece 2001, Slovenia 2007, Cyprus These countries include Greece 2001, Slovenia 2007, Cyprus 2008, Malta 2008, Slovakia 2009, and Estonia 2011.2008, Malta 2008, Slovakia 2009, and Estonia 2011.

Membership of the Economic & Monetary Union Membership of the Economic & Monetary Union (EMU)(EMU)

To be part of the economic and monetary union To be part of the economic and monetary union (EMU), EMS members must….(EMU), EMS members must….

1.1. first adhere to the ERM: exchange rates were fixed in first adhere to the ERM: exchange rates were fixed in specified bands around a target exchange rate,specified bands around a target exchange rate,

2.2. next follow restrained fiscal and monetary policies as next follow restrained fiscal and monetary policies as determined by Council of the European Union and the determined by Council of the European Union and the European Central Bank,European Central Bank,

3.3. finally replace the national currency with the euro, finally replace the national currency with the euro, whose circulation is determined by the European whose circulation is determined by the European System of Central Banks.System of Central Banks.

Why the Euro (EMU)?Why the Euro (EMU)?

EU members adopted the euro for principally 4 reasons:EU members adopted the euro for principally 4 reasons:

1.1. Unified marketUnified market: the belief that greater market integration : the belief that greater market integration and economic growth would occur.and economic growth would occur.

2.2. Political stabilityPolitical stability: the belief that a common currency would : the belief that a common currency would make political interests more uniform.make political interests more uniform.

3.3. The belief that The belief that German influenceGerman influence under the EMS under the EMS would be would be moderatedmoderated under a European System of Central Banks. under a European System of Central Banks.

4.4. Eliminate the possibility of devaluations/revaluationsEliminate the possibility of devaluations/revaluations : : with free flows of financial capital, capital flight and with free flows of financial capital, capital flight and speculation could occur in an EMS with separate currencies, speculation could occur in an EMS with separate currencies, but would be more difficult with a single currency.but would be more difficult with a single currency.

III. The Mechanism under EMSIII. The Mechanism under EMS

A weighted basket or composite of the EU currencies called A weighted basket or composite of the EU currencies called the European Currency Unit (ECU) floated against non-EU the European Currency Unit (ECU) floated against non-EU currencies. currencies.

Within the ERM, each central bank intervened in foreign Within the ERM, each central bank intervened in foreign exchange markets to keep the value of its currency fixed exchange markets to keep the value of its currency fixed within a prescribed band against the ECU and, thereby, within a prescribed band against the ECU and, thereby, against other currencies. against other currencies.

Attempts to maintain fixed but adjustable exchange rates Attempts to maintain fixed but adjustable exchange rates among countries that follow divergent macroeconomic among countries that follow divergent macroeconomic policies are fraught with difficulties. policies are fraught with difficulties. HOW!!HOW!!

When individual countries follow divergent policies, those When individual countries follow divergent policies, those policies create pressures for exchange rate realignments. policies create pressures for exchange rate realignments. HOW!!HOW!!

IV.The EMS from 1979–1998IV.The EMS from 1979–1998

From From 1979–19921979–1992, the EMS defined the exchange rate , the EMS defined the exchange rate mechanism to allow most currencies to fluctuate +/- 2.25% mechanism to allow most currencies to fluctuate +/- 2.25% around target exchange rates.around target exchange rates.

The exchange rate mechanism allowed larger fluctuations (+/- The exchange rate mechanism allowed larger fluctuations (+/- 6%) for currencies of Portugal, Spain, Britain (6%) for currencies of Portugal, Spain, Britain (until 1992until 1992) and ) and Italy (Italy (until 1990until 1990).).

These countries wanted greater flexibility with monetary These countries wanted greater flexibility with monetary policy.policy.

The wider bands were also intended to prevent speculation The wider bands were also intended to prevent speculation caused by differing monetary and fiscal policies.caused by differing monetary and fiscal policies.

In general, the period between 1987- mid 1992 was one of the relative In general, the period between 1987- mid 1992 was one of the relative quit on monetary front in Europe, but the quiet didn’t last !!quit on monetary front in Europe, but the quiet didn’t last !!

During 1992, because of differences in monetary and fiscal policies During 1992, because of differences in monetary and fiscal policies across the EMS, markets participants began buying German assets across the EMS, markets participants began buying German assets (because of high German interest rates) and selling other EMS assets.(because of high German interest rates) and selling other EMS assets.

As a result, Britain left the EMS in 1992 (Black Wednesday) and As a result, Britain left the EMS in 1992 (Black Wednesday) and allowed the pound to float against other European currencies.allowed the pound to float against other European currencies.

In addition, at the same year Italy left the ERM but reentered in 1996.In addition, at the same year Italy left the ERM but reentered in 1996.

As a result, exchange rate mechanism was redefined in 1993 to allow As a result, exchange rate mechanism was redefined in 1993 to allow for bands of +/-15% of the target value in order devalue many for bands of +/-15% of the target value in order devalue many currencies relative to the deutschemark.currencies relative to the deutschemark.

V. Maastricht Treaty Single European Act of 1986 recommended that many barriers to

trade, financial capital flows and immigration be removed by December 1992. It also allowed EU policy to be approved with less than

unanimous consent among members.

Maastricht Treaty, proposed in 1991, required some provisions to transform the EMS into a economic and monetary union.

The The Maastricht Treaty led to the creation of the euro, also the led to the creation of the euro, also the treaty created what was commonly referred to as the pillar treaty created what was commonly referred to as the pillar structure of the European Union.structure of the European Union.

These three pillars include the European Community (EC) pillar, the European Community (EC) pillar, the Common Foreign and Security Policy (CFSP) pillar, and the the Common Foreign and Security Policy (CFSP) pillar, and the Justice and Home Affairs (JHA) pillar.Justice and Home Affairs (JHA) pillar.

Maastricht Treaty, proposed in 1991, required some provisions to transform the EMS into a economic and monetary union.

Maastricht Treaty also required standardizing regulations and centralizing foreign and defense policies among EU countries.

However, some EU/EMS members have not ratified all of the clauses in the Maastricht Treaty.

The The Maastricht Treaty requires that members want to requires that members want to enterenter the the economic and monetary union have to follow specific convergence economic and monetary union have to follow specific convergence indicatorsindicators (the convergence criteria) (the convergence criteria)..

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.