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Successes of the single market program, the EMS and the economic convergence created a favorable eco

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Successes of the single market program, the EMS and the economic convergence ... Commercial banks used the euro in interbank transactions. ... – PowerPoint PPT presentation

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Title: Successes of the single market program, the EMS and the economic convergence created a favorable eco


1
Towards the European Monetary Union (EMU)
  • Successes of the single market program, the EMS
    and the economic convergence created a favorable
    economic and political climate for the
    establishment of a full-fledged monetary union.
  • EMS was successful in insulating intra-European
    trade from turbulence in global currency markets
    and from the wild swings in the value of the
    dollar that marked the Reagan years.
  • As EMS evolved into a de facto fixed rate regime,
    the logical step became a move to full EMU.
  • Recognition that single market program was
    inconsistent with different currencies within the
    EC as currency fluctuations affected the prices
    of goods and services and constituted a barrier
    to trade (transaction costs). One Market, One
    Money

2
Delors Report (1989) and the Maastricht Treaty
(1991)
  • Based on principles of gradualism and
    convergence.
  • Delors Report was approved in 1989 (Madrid
    European Council)
  • Defines three stages in the process towards
    monetary union.
  • First Stage (from 1 July 1990 to 31 December
    1993) The EMS countries abolished all remaining
    capital controls (Free movement of capital). The
    degree of monetary cooperation among the EMS
    central banks were strengthened. Realignments
    were possible. Member states undertake programs
    that make possible fixed exchange rates.
  • Second Stage (from 1 January 1994 to 31 December
    1998) A new institution, the European Monetary
    Institute (EMI) was created.

3
The Maastricht Treaty (1991)
  • The European Monetary Institute (EMI) was a
    precursor to the European Central Bank (ECB) and
    was created to
  • Coordinate monetary policies and ensure price
    stability.
  • Prepare the establishment of the European System
    of Central Banks (ESCB) overseen by the European
    Central Bank (ECB).
  • Prepare the introduction of a single currency in
    stage 3.
  • Examine the achievement of economic convergence
    among EU states as established by the Maastricht
    Treaty (1992).

4
The Maastricht Treaty (1991)
  • Third (Final) Stage (from 1 January 1999 to 31
    June 2002) The exchange rates were irrevocably
    fixed. Establishment of the European Central Bank
    in charge of the European monetary policy. The
    ECB issued the euro. The transition to this
    final stage was made conditional on a number of
    convergence criteria.
  • Third Stage was divided into three sub-stages
  • From 1 January 1999 until 31 December 2001, the
    national currencies continued to circulate
    alongside the euro, albeit at irrevocably fixed
    exchange rates. Commercial banks used the euro in
    interbank transactions. Individuals had the
    choice of opening euro accounts. Note that during
    this period the euro did not exist in the form of
    banknotes and coins. All transactions between the
    ECB and commercial banks were in euros. New
    issues of government bonds were also in euros.

5
The Maastricht Treaty (1991)
  • During the period 1 January to 1 July 2002, the
    euro would replace the national currencies which
    would lose their legal-tender status.
  • From 1 July 2002 on, a true monetary union would
    come to existence in which the euro would be the
    single currency managed by one central bank, ECB.
  • The Maastricht Treaty was finally ratified in the
    fall of 1993 and 12 countries (except UK, Sweden
    and Denmark) began to implement Stage 2 of EMU-
    the convergence phase in which states were
    required to cut their deficits and lower
    inflation to qualify for Stage 3.

6
What is Monetary Union?
  • Weak version
  • Fixed bilateral exchange rates (rigidly or
    within a band)
  • Each member undertakes monetary policies to
    defend the rates
  • Strong version
  • Individual currencies are replaced by a single
    currency
  • Individual monetary authorities are replaced by a
    single authority

7
Maastricht Treaty (1991) The Convergence
Criteria for Membership in EMU
  • A country can join the union only if
  • Price stability
  • For the preceding year the average inflation rate
    must not exceed that of the three best-performing
    states (with lowest inflation) by more than
    1.5.
  • Interest rate convergence
  • For the preceding year the average long-term
    interest rate must not exceed that of the best
    three states (with lowest inflation) by more than
    2.
  • Budget discipline
  • Government budget deficit must be less than 3 of
    GDP.
  • Government (Public) debt cannot exceed 60 of
    GDP.

8
Maastricht Treaty (1991) The Convergence
Criteria for Membership in EMU
  • Exchange rate stability
  • During the two years preceding the entrance into
    the union, no exchange rate realignments. This
    means two years membership in the ERM without
    devaluation.
  • Independent CB with price stability as its
    primary objective.
  • Motivation for the Maastricht Criteria
  • Impose fiscal prudence and prevent free riding
    (e.g. on low interest rates)
  • Eliminate threat of national governments seeking
    bail-outs from the ECB.
  • Increase stability of the EMU and the common
    currency.
  • Stability and Growth Pact (1996)

9
The European Monetary Union (2002)
  • In May 1998, 11 EU countries satisfied the
    convergence criteria with the exception of
    Greece. Denmark, Sweden and the UK decided to
    stay out of Euroland despite the fact that they
    satisfied the convergence criteria. Sweden
    deliberately failed to satisfy the requirement of
    ERM membership. Danish subjected its entry to a
    national referendum.

10
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12
Implications of EMU
  • Economic Union
  • Customs Union Free movement of goods and
    services, mutual recognition of norms and
    standards (i.e. no non-tariff barriers), common
    external tariff.
  • Free mobility of capital and labor
  • EU-wide competition policy
  • Coordination of macroeconomic policies
  • Economic and social cohesion (solidarity) and
    regional development.

13
Implications of EMU (II)
  • Monetary Union
  • Irrevocably fixed exchange rates
  • Replacement of national currencies by the euro.
  • Single monetary policy determined by an
    independent ECB
  • Restrictions on and coordination of national
    fiscal policies

14
Implications for Macroeconomic Policy
  • Single Interest Rate set by the ECB
  • Exchange rates can not be readjusted to correct
    for changes in fundamentals (e.g. inflation
    differential between two countries)
  • Single Monetary Policy? ECB is nominally
    independent although representatives of national
    CBs sit on ECB council.
  • Monetary policy can not respond to country
    specific shocks.
  • Use of Fiscal Policy as an adjustment policy is
    limited by the Maastricht Criteria? Prices may
    need to be more flexible (micro flexibility),?
    labor mobility may need to bear a greater share
    of adjustment to shocks,
  • ? Increased need for fiscal risk sharing, case
    for fiscal federalism?

15
Costs and benefits of the Euro
  • Benefits
  • Reduction in transaction costs.
  • Elimination of the exchange rate risk.
  • Greater competition leading to greater
    efficiency.
  • Greater integration among the European financial
    markets and greater investment efficiency.
  • Inflation discipline guaranteed by the
    independence of the European Central Bank.
  • Fiscal discipline as a requirement to enter and
    stay in the system.
  • Increase the urgency of structural reforms in
    Europe.

16
  • Costs
  • The system of fixed exchange rates eliminate the
    possibility of using exchange rate adjustments as
    a policy tool in the presence of asymmetric
    shocks.
  • Individual countries cannot use monetary policy
    to face country-specific shocks.
  • Europe may not be an optimal currency area due
    to
  • Likelihood of asymmetric or country-specific
    shocks.
  • Limited labor mobility.
  • Structural labor market rigidities.
  • Limited ability to use fiscal policy as a
    stabilization tool in absence of monetary
    independence.
  • Absence of a system of fiscal redistribution to
    insure against regional/national shocks.
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