Euro / Monetary Union

Question 1

Joining the Euro involves

Answer 1

• Replacing domestic currency with Euros.
• No possibility of fluctuating exchange rates within the Euro area.
• A common monetary policy. Interest rates are set by the ECB for the whole Eurozone area.
• Rules about size of budget deficits (3% of GDP). Fiscal stability pact – though in practise, this is often broken.

Question 2

Advantages of Joining the Euro 1

Answer 2

1. Lower transaction costs - If the UK joins the Euro, firms and tourists will not have to pay the cost of converting currencies; this will make trade more profitable (costs 1% of GDP).
2. Eliminate exchange rate fluctuations - If UK exporters experienced a rising Pound Sterling, it makes their exports less competitive. If exchange rates are fixed then firms can invest in export capacity with more confidence about future export prices.
3. Increased inward investment. With stable exchange rates and the abolition of transaction costs it will be more desirable to invest in the UK. If we stay out of the Euro we could lose out on this.

Question 3

Advantages of Joining the Euro 2

Answer 3

4. Greater Price Transparency - With a common currency it is easier to compare prices in different EU countries. This should hopefully lead to greater price competition. Also it should be easier for firms to identify the cheapest suppliers.
5. The UK financial sector would benefit. In the Euro, it may be easier to buy shares in German or French companies, British Banks would find it easier to set up in the Eurozone.
6. Lower Inflation. The ECB has a strong tradition of keeping inflation low. Joining the Euro will help reduce inflation expectations. In theory joining the Euro should give countries an incentive to remain competitive and increase productivity because they cannot rely on devaluation to improve competitiveness.

Question 4

Disadvantages of Joining the Euro 1

Answer 4

1. Lack of exchange rate flexibility - If the UK joins the Euro at an exchange rate that is too high, it would make UK exports uncompetitive because it is not possible to devalue the exchange rate.
   - Several countries in the Eurozone experienced a deterioration in competitiveness between 2000 and 2007. This caused very high current account deficits and lower exports, which led to low economic growth.
   - Being able to devalue the currency can help economic recovery in a recession. In Europe, countries had to restore competitiveness through deflation – lower prices and lower wages, instead of the exchange rate. But, this caused high unemployment.
2. Low inflation may conflict with other objectives - It is argued that the ECB is too concerned with low inflation and ignores other macro economic objectives such as growth and unemployment.

Question 5

Disadvantages of Joining the Euro 2

Answer 5

3. The UK will lose ability to set interest rates - The ECB set interest rates for the whole Eurozone. However, this may not be suitable for the UK economy.
   • For example, if the UK was in a deep recession but Europe was growing, the ECB would set a high interest rate. This high interest rate would make it difficult for the UK to recover and grow. (e.g. in 2008/09)
   • If ECB rates were too low, the UK may experience inflation.
4. Loss of independence over fiscal policy - The growth and stability pact limits government borrowing to no more than 3% of GDP. To reduce budget deficits, several Eurozone economies pursued austerity measures (spending cuts). But, trying to balance the budget in a recession causes a further fall in AD and higher unemployment.

Question 6

Disadvantages of Joining the Euro 3

Answer 6

5. Lack of convergence in the UK There are number of reasons why the UK economy may never converge with Euro zone:
   • The UK housing market is more volatile, low interest rates may cause a soaring housing market, which would create other economic problems
   • There have been times when the UK business cycles has been out of step with the EU e.g. in 1992 when the UK suffered a severe recession.
6. Bond yields. Countries in the Euro, such as Greece, Italy and Spain have seen very high bond yields on government debt. This is because in the Euro, there is no Central Bank willing to print money and act as lender of last resort. During the European fiscal crisis, the UK benefitted from low bond yields because the Bank of England could intervene in the bond market if necessary.