Week 4: Monetary Union

Question 1

Benefits of Monetary Union

Answer 1

1. Direct and indirect benefits from the elimination of transaction costs/ transparent prices.
2. Welfare gains from less uncertainty and gains from elimination of the exchange rate risk
3. Access to large liquid financial markets

–>Benefits of a monetary union are likely to increase with the degree of openness of an economy and its volume of international trade

Question 2

Costs of Monetary Union

Answer 2

*Nations are no longer able to
* devalue or revalue their currency (i.e., exchange rate policy)
* determine the quantity of the national money in circulation
* change the short-term interest rate
*asymmetric shock probability
*Countries with higher inflation may have to undergo a stabilization crisis.
*Spill over effects from high government borrowing.

Question 3

Criteria for OCA (Optimum Currency Area)

Answer 3

Economic criteria:
*Labour mobility (Robert Mundell)
*Diversification (Peter Kenen)
*Openness (Ronald McKinnon)
Political criteria:
*(Fiscal) transfers
*Homogeneous preferences
*Degree of solidarity

Question 4

Asymmetric demand shock

Answer 4

Decline in aggregate demand in one country and increase or no change in another country.
Possible adjustments:
1. Restrictive (expansionary) monetary policy in Germany (France)
2. Wage and price flexibility in both countries
3. Labor mobility (from France to Germany)
4. Devaluation of the French currency vis-á-vis German Deutsche Mark
5. Transfers from Germany to France (i.e., budgetary/fiscal union)
6. National fiscal (spending) policy (often limited by crowding out and)

1&4 ruled out–> monetary union
5&6 limited
real solutions are 2&3

Question 5

Convergence criteria for EMU qualification

Answer 5

1. Inflation rate
   must not exceed the average inflation rate of the three countries with the lowest inflation rates by more than 1.5 percentage points.
2. long-term interest rate
   must not exceed the average long-term interest rate of the three countries with the lowest inflation rates by more than 2 percentage points.
3. exchange rate
   must have been without tensions within the „normal“ exchange rate band for the last 2 years before entry into EMU.
4. Fiscal deficit
   must not exceed 3 percent of GDP.
5. Government debt
   must not exceed 60 percent of GDP.

Question 6

Voting system of ECB

Answer 6

Rotating rights system:
<used to be 2 groups>
3 groups within rotation:
1. First group with 4 votes consists of the ‘big 5’
2. Second group, with 8 votes, will consist of half of all governors selected from the subsequent
positions in a ranking based on size of economy
3. Third group will be composed of the remaining governors with 3 votes

Question 7

ECB’s main obejctive

Answer 7

Maintain price stability.
Support general economic policies to do so, control inflation target.

Question 8

Role of Euro

Answer 8

Must fulfil the same conditions as a national currency.
The classic attributes of money are:
* medium of exchange used for commercial transactions;
* unit of account;
* store of value.

Externally, a currency can be:
* an international unit of account: trade invoicing;
* an international medium of exchange: a vehicle currency;
* an international store of value: bond market, foreign exchange reserves, individual hoarding.

Question 9

Banking Union: regulation

Answer 9

• Bank capital
  Banks must have an amount of capital equal to 8% of ‘risk weighted assets’;
  Capital is the amount of shares issued by the bank and represents the value of the bank to
  its owners;
  The bank itself assesses the quality of its assets.
• Leverage ratio
  The leverage ratio relates borrowing (liabilities) to capital [i.e., debt-to-equity];
  It will be closely monitored, and the authorities can require that it be reduced.
• Liquidity ratio
  Ratio of assets that can be promptly and safely sold to obtain cash as a proportion of payments that a bank expects to make over the next 30 days;
  This ratio will have to be progressively raised to 100 per cent.

Question 10

Banking Union: supervision

Answer 10

Single Supervisory Mechanism (SSM)
->Largest banks under authority of ECB
Because systemically important banks potentially are the source of massive spillovers.
->The smaller banks remain subject to national supervision.

Question 11

Banking Union: resolution

Answer 11

Single Resolution Mechanism (SRM)
-> Responsible for all large (systemically important) banks.
->Resolution of a bank is decided by the SRB and carried out by the relevant national resolution authority
->Funding for any cash injection is provided by a new resolution fund.