The Euro

Question 1

Why did exchange rate volatility concern Europeans?

Answer 1

• European economies are very open
• Wide exchange rate fluctuations led to crisis between wars

Question 2

Discuss what is meant by European economies being open.

Answer 2

• International trade important for national income
• High share of exports and imports in total income

Question 3

What are the Bretten Woods agreements?

Answer 3

• Established a way to keep exchange rate volatility in check
• System of currencies with common peg to the US doll
• Central rate with any deviations kept within narrow band (0.75%)

Question 4

How did the Bretton Woods agreement collapse in 1970?

Answer 4

• US had to fund Vietnam war
• Monetary policy used to finance fed deficit - led to inflation

Question 5

What is the European Monetary system?

Answer 5

Exchange rate agreement but only for European countries that used the Deutschmark as benchmark currency

Question 6

What is the Maastricht Treaty?

Answer 6

• The decision to adopt a single currency
• Convergence criteria for countries aspiring to join
• Creation of the European Central Bank

Question 7

Why did countries want to adopt the Euro?

Answer 7

As it was impossible for countries to devalue it - a condition for starting the EMU was the convergence of macroeconomic variables

Question 8

What was the inflation rate criteria for admission to the EMU?

Answer 8

Cannot be more than 1.5pp above three best performing states

Question 9

What was the public deficit and debt criteria for admission into the EMU?

Answer 9

• Ratio of government deficit to GDP must not exceed 3%
• Ratio of government debt to GDP must not exceed 60%

Question 10

What is the Exchange Rate criteria for admission into the EMU?

Answer 10

For at least 2 years, fluctuations are within the band.

Question 11

What was the Long term interest rate criteria for admission into the EMU?

Answer 11

Average long term rate that does not exceed by more than 2 pp that of the three best performing members using long term gov. bonds

Question 12

What conditions are relevant for an optimal currency area?

Answer 12

• Countries face similar shocks
• Countries have high factor mobility

Question 13

Discuss labour mobility in the EU.

Answer 13

• EU has low labour mobility when compared to other monetary unions such as the US
• Labour mobility has been rising since 2000 with enlargement of the EU to the east and movements between other member states

Question 14

Is Europe an optimal currency area?

Answer 14

• Low labour mobility in Europe is not optimal
• Asymmetric shocks may be common but adjustment mechanism is not really there
• Lack of adjustment mechanisms mean a lot of time prices must adjust - long process

Question 15

What are the microeconomic benefits of a monetary union?

Answer 15

• Reduced uncertainty - volatile exchange rates will not affect prices and demand
• Reduced transaction costs - cost of fx transactions are avoided
• Price transparency

Question 16

What are the macroeconomic benefits to a monetary union?

Answer 16

• Anti-inflationary reputation - easier to control inflation
• Monetary policy coordination - interest rate differences are less common
• Trade effects

Question 17

What is the major cost of monetary unions?

Answer 17

The loss of exchange rate as an automatic stabiliser in the event of asymmetric shocks.