Lecture 11 - Economic and monetary union in Europe

Question 1

What does the European monetary union (EMU) involve?

Answer 1

1- Single currency (Euro) which replaces national currencies therefore there are no exchange rates within the EMU and there is a single ER against other countries
2- Institutions to determine and administer monetary policy (ECB)
3- Unified monetary policy
4- Free movement of capital
5- Coordinated tax policies

Question 2

What is the Maastricht convergence criteria for joining the EMU?

Answer 2

1- Prior convergence in inflation rate: The inflation rate must not be more than 1.5% above the average of the best 3 EU countries
2- Interest rate convergence: The long term interest rate must not be more than 2 percentage points above the average of the best 3 EU countries on inflation
3- Budgetary convergence: The country must have an annual budget deficit of less than 3% GDP
4- Accumulated public (national debt): Public debt must not be more than 60% of GNP
5- No devaluation: There must be no devaluation of the exchange rate for 2 or more years before attempting to enter the EMU

Question 3

Explain the European Central Bank’s role

Answer 3

• The Eurozone monetary policy is set by the ECB governing council which meets fortnightly in Frankfurt to decide interest rates
• The ECB executive board implements decisions and sets agendas

Question 4

What is the ECB’s main objective?

Answer 4

• By Treaty, the ECB’S main objective is price stability/keep inflation low and avoid deflation
• This should support growth and employment
• The ECB’s other key job is to maintain stability and the integrity of the financial system

Question 5

Explain how the ECB conducts its monetary policy duties

Answer 5

• The ECB conducts monetary policy (MP) on behalf of the Eurozone as a whole - 20 countries
• The main instrument of monetary policy is the interest rate at which the ECB lends to and borrows from other banks

Question 6

How does the ECB influence the interest rate?

Answer 6

The ECB influences the interest rate by lending policies towards commercial banks

Question 7

How does the ECB set interest rates?

Answer 7

• The ECB raises interest rates if medium term inflation prospects rise and vice versa
• It mainly sets interest rates through open market operations: commercial banks obtain liquidity (cash) by offering collateral (government bonds etc that they own) to ECB and paying an interest rate