8. Optimal Currency Areas

Question 1

Why did the Bretton Woods system collapse?

Answer 1

In 1973, the system of fixed exchange rates collapsed as a result of speculative attacks. Countries faced fundamental equilibrium and couldn’t maintain the peg while dealing with their own domestic economic turmoil

Question 2

What’s the key difference between EMS and the Bretton Woods System?

Answer 2

EMS imposed capital controls to prevent money from freely flowing out of the country in order to stop speculative attacks while the Bretton Woods system didn’t
(When they lifted the capital controls in 1992, they opened themselves up to speculative attacks again)

Question 3

How did the EMS cope with inflation?

Answer 3

By pegging their currencies to the German Deutsch Mark (GDM) because the German Central Bank was known for fighting inflation

Question 4

What is the credibility theory of the EMS?

Answer 4

The political cost of violating an international exchange rate agreement can help restrain the government from devaluing their currency

• EMS countries inherited the German reputation of being inflation fighters
• All inflation was brought to the same level

Question 5

What is the Delors Report?

Answer 5

Outlined the three stages of economic and monetary union of currency and monetary policy

Question 6

What were the conditions of the Maastricht treaty?

Answer 6

1. The country’s inflation must be less than 1.5% above the average of the 3 EMS countries with the lowest inflation
2. Country must maintain a stable peg to the currency for a few years
3. Deficit must be less than 3% of their GDP
4. Debt must be less than 60% of their GDP

Question 7

Why move towards a single currency?

Answer 7

1. Greater economic integration
2. Political stability by forming one bigger political unity
3. Protect against speculative attacks
4. Remove the asymmetry of the GDM

Question 8

What are the benefits of adopting a common currency?

Answer 8

1. Simple economic integration calculations (monetary efficiency gains)
2. International price convergence
   - Pegged to low inflation = low inflation at home
   - Increased competition leads to lower prices

Question 9

What are the costs of adopting a common currency?

Answer 9

1. Loss of monetary policy autonomy
2. Loss of the use of exchange rates as automatic stabilisers
   The size of this cost is dependent on how similar the economies are

Question 10

What’s the optimum currency criteria?

Answer 10

1. Business cycle synchronisation
2. Labour mobility
3. Wage flexibility
4. Common language and border
5. Fixed transfers
   Europe is not an optimum currency area