8. European Monetary Union

Question 1

Currency Union | Definition

1.
2.

Answer 1

• common currency area = geographical area through which one currency circulates and is accepted as the medium of exchange
• also: currency onion / monetary union

Question 2

What are potential benefits of joining a currency union?

1.
2.
3.
4.

Answer 2

• reduction on exchange rate uncertainty
• reduction in transaction costs and complexity
• reduction in price discrimination across countries
• political advantages

ATUD

Question 3

Explain why the following are benefits of joining a currency union, with examples:

1. reduction on exchange rate uncertainty
2. reduction in transaction costs and complexity
3. reduction in price discrimination across countries
4. political advantages

Answer 3

1. german companies export to other euro area countries dont have uncertainty anymore regarding the value of their receipts
2. no charges anymore for exchanging currencies when trading (for the euro area estimated to be up to 0.5% of GDP)
3. price differences easier to spot not when thinking about cross-border shoppping, potentially leading to more competition/ efficiency
4. e.g. increase in global political power due to more important currency or economic advantages for your country, e,g. lower interest rate - STILL at the expense of others in the union

Question 4

What are potential costs of joining a currency union?

1.
2.
3.
4.

Answer 4

I P P F

1. Losing independent monetary policy and flexible
   exchange rate adjustments to deal with shocks (“one
   size fits all” interest and exchange rates approach)
2. losing power to intervene on exchange rate markets to achieve overvaluing or undervaluing own currency
3. (some) loss of fiscal policy sovereignity ( (due to the
   fiscal rules keeping the union stable)
4. political disadvantages (e.g. giving power to supranational institutions and having to compromise in negotiations with other union members)

Question 5

Potential costs of joining a currency union – How do
flexible exchange rates dampen asymmetric shocks?

1.
2.
3.

Answer 5

• assume a shock leads to demand for french goods to increase and germany goods to decrease
• franc appreciates against d mark (less net exports franc)
• flexible exchange rates allow dampening the effects of the shock

Question 6

Potential costs of joining a currency union - How do monetary policies dampen asymmetric shocks?

1.
2.
3.

Answer 6

• assume a shock leads to demand for french goods to increase and germany goods to decrease
• independent monetary policy: french raises interest rates to cool down economy -> dampening the shocks
• so, both is possible

Question 7

Whats the Optimum Currency Area Theory? What are the factors reducing the cost of a common currency?

1. Definition
2. Factor A
3. Factor B
4. Factor C
5. Factor D

Answer 7

• defines criteria that a group of countries should satisfy to make it optimal for them to form a currency union:
• real wage flexibility, allowing for quick shock adjustments within countries (eg wages dropping in germany)
• labor mobility, allowing for shock adjustments across countries (eg germany moving to france to work)
• capital mobility, allowing for shock adjustments across countries (germans borrowing from french to make up for income drops)
• symmetric macroeconomic shocks, allowing for common optimal policy response (the more similar economies are in structure, (skilles or unskilled, eg), the more likely shocks are symmetric), i.e IS TRADE INTENSE?

Question 8

What are factors increasing the benefits of having a common currency?

1.
2.

Answer 8

• most benefits focused around a common currency making trade easier and cheaper
• i.e. the more intense trade is among a group of countries, the larger are the benefits!

Question 9

What are the two economic main reasons (2) and the two political reasons (2) for european countries to form a currency union?

1.
2.
3.
4.

Answer 9

• less exchange rate uncertainty/currency speculation
• reduced transaction costs leading to greater economic integration
• more aligned econiomic and political interests (more stability and integration)
• more moderated german influence under a european system of central banks

Question 10

1. When was the European Monetary sytem formed?
2. what were the consequences in the consecutive years?
3. when was the euro formally stated?

Answer 10

1. 1979
2. over time it led to inflation rate convergence
3. around 2000

Question 11

is the euro area an optimal currency area, according to the following key criteria?

1. is trade intense across national borders
2. Are macroeconomic shocks symmetric across
   national borders?
3. Is capital mobile across national borders?
4. Is labor mobile across national borders?
5. Are real wages flexible?

Answer 11

1. yes
2. for most of the time; e.g. GDP growth
3. not really, only equity investments with upwards trend
4. not really, people prefer being unemployed
5. not really, wages are rather rigid

Question 12

To adjust to asymmetric macroeconomic shocks, a
country in the Euro area cannot us….
1.
2.
But in principle, it can still use…
3.

Answer 12

1. individual monetary policy
2. individual exchange rate adjustment
3. fiscal policy to adjust.

Question 13

What is the free rider issue in fiscal policy? What are the two key problems?

Answer 13

• usinf fiscal policy by running budget deficit can have negative externalities for other euro countries:
  1. increasing interest rates, which other euro governments have to pay on their debt (if other countries bail out the one)
  2. inflation is increased across the whole euro area

Question 14

How can the free rider issue be adressed when formin a currency union?

1.
2.
3.

Answer 14

• only letting members with sound government finances join (e.g. exchange rate stability; price stability with max inflation rate; restricitve fiscal policy (budget deficit GDP only 3%; government debt only 60%))
• Make sure members keep their finances sound
  after they have joined, e.g. be prepared to pay fines up to 0,5% of GDP
  − Commit not to bail out any member

Question 15

The Euro Crisis in Short

1.
2.
3.
4.
5.

Answer 15

• Introducing the Euro decreased interest rates for Euro
  area countries to German levels. Financial markets believed
  that no Euro area country would ever default on its debt
  again.
• During the financial crisis financial markets started to have
  doubts regarding Greece and their interest rates increased.
• Euro area decided to bail-out Greece (and others such as
  Portugal or Ireland) with support programs
• ECB announced “Outright Monetary Transactions“ (OMT)
  in 2012, i.e. that it would buy Euro area member government
  bonds if necessary.
• Bailouts and OMT basically signaled that the Euro
  area/ECB in the end would pay for any Euro area
  country‘s debt if necessary. Interest rates started to align
  again.