4b: Benefits of a Monetary Union

Question 1

What is a MU?

Answer 1

• process of reducing XR volatility (= risk) between national currencies
• considered as the highest form of integration.
• European Monetary System: Fixing the XRs of European countries to a common standard (mostly the Deutsche Mark), thus reducing the volatility of XRs

Question 2

Benefits of a MU

Answer 2

1. Direct and indirect benefits from the elimination of transaction costs/ transparent prices
2. Welfare gains from less uncertainty and gains from elimination of the XR risk
3. Credible monetary policy
4. More powerful lender of last resort
5. Large liquid financial market offering a far wider range of investment and financing opportunities

Gains of a monetary union are likely to increase with the degree of openness of an economy and its volume of international trade

Question 3

Benefits of TAC Reduction

Answer 3

Direct gains:

• Elimination of the costs of exchanging one currency against another
• Abolition of the commission paid to the bank, when exchanging national currencies
• Reduction of traveling burden

Indirect gains:

• Prices for goods and services can be compared at a glance
• Thereby the Euro also contributes to financial integration.
• Cost reduction amounts to 0.25 to 0.5% of GDP (according to the European Commission)

Question 4

Benefits of Less XR Uncertainty

Answer 4

1. XR uncertainty introduces insecurity about the future prices of goods and services:

• Economic agents base their decisions on the information that the price system provides them
• If prices become more uncertain the quality of the decisions declines

2. Eliminating the XR risk of cross border investment within the currency union

• increases investment
• increases the efficiency of the international allocation of capital

3. Experience of the 1920s and 1930s

• Crisis of national economies in the inter-war period
• Competitive devaluations as an instrument to exit from the deep recession  retaliation of trading partners  next step tariffs and duties  retaliation of (former) trading partners  collapse of free trade

4. Open economies

• International trade is very important component of national income
• Importance of volatility increases with “degree of openness”

5. CAP as the only tangible activity of the EU until the early 1980s

• Since the start of the CAP in the 1960s, the price of agricultural products has been the same in all European countries
• Frequent changes in XRs would harm the common agricultural market seriously

Question 5

Credible Monetary Policy

Answer 5

• high inflation rates = high rates of interest
• goal: price stability
• lack of independent national monetary policies preserved the low inflation
• Countries with a tradition of high inflation benefit from the imposed discipline

Question 6

Lender of Last Resort

Answer 6

• Commercial banks experience liquidity problem > need for a lender of last resort
• Central banks provide liquidity against illiquid collateral
• Needs of a domestic bank or a group of banks may exceed the appropriate lending ability of the national central bank and the fiscal capacity of the national government, especially if the banks are in need of foreign exchange (e.g. Iceland, Hungary)
• ECB represents a more powerful lender of last resort than national central banks
• However: Pronounced Moral Hazard problem > Once the EU has intervened, the country (politicians?) might not have an incentive to consolidate their budget.

Question 7

Benefits of an International Currency

Answer 7

• Additional revenues for the issuer. How the total amount of profit is less than 0.5% of US GDP
• As euros are held by foreign central banks as international reserve, it allows the EU to easily finance a potential budget deficit
• As an international currencies the € strengthens economic activity in European financial markets.