Financial and Monetary Economics
European Monetary Union (EMU)
The evolution of EMU involved three steps which are illustrated as (Baldwin, Charles 2004)
StageBeginning dateComponents1st1st July 1990Free capital movement
Increasing Structural funds aimed at eliminating inequalities between members of the region
Formation of Economic union through analyzing the policies of member states2nd 1st January 1994European Monetary Institute was formed which comprised of Central Bank Governors of the member countries
National Central Banks were made independent
Rules for limiting budget deficits were defined3rd1st January 1999Euro was born
The European Central Bank took charge of European Monetary Institute and formed the Monetary policy for Euro1st January 2002Euro notes and coins were issued to all the member countries and later on their national currency was taken away.Criteria for EU Countries
The eligibility criteria for EU countries involve the following
Maintenance of Price This is done in relativity to the three members having the lowest inflation rates. The inflation rate for each member should not go over the average rates of these countries by a percentage greater than 1.5
Inflation Control This is also done as per the criteria of Price maintenance but the relativity is checked for long-term interest rates. This variance should not be more than a percentage of 2 than the average rates of three members having the lowest inflation rates.
National Budget deficits this is checked in relative to the GDP where the value should not exceed 3percent of the economic GDP.
Public debt This is also checked in relative to the GDP where the value should be below 60 of the Economic GDP.
Maintenance of exchange rate There is a margin authorized for the exchange rates. The rates must be maintained according to that margin.
Euro Countries
The following are the countries that fit to the above criteria and have adopted the euro as their currency
YearMembers1999Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain2001Greece2007Slovenia2008Cyprus, Malta2009SlovakiaBudget
Deficit Maintenance
A main contributor to the Economic Stability, the Stability and Growth Pact, was formed in June 1997 and later on revised in March 2005. This was done in order to control budget deficits of the member countries according to the criteria defined and also impose penalties on those not fulfilling the requirements, thus maintaining budgetary disciplines among the members and controlling excessive deficits.
Formation of Euro Group
The Euro group is formed to conduct meeting of the finance ministers of the member countries of the Eurozone (Euro Economics). The meetings are done with the following aims
Economic Policies Coordination of all the member countries
Control over Budgetary and other Financial policies
Representation of Euro in other global forums
Optimal Currency Areas (OCA)
Optimal Currency area is categorized according to geographical boundary where the entire region within that boundary holds a single currency. The region is formed by analyzing combination of currencies or formation of a single currency which would enhance economic efficiency. There are cases of OCA where the Optimal Currency area can be smaller or larger than a country. With a single currency, OCA therefore provides a fixed exchange rate between the participants belonging to that region. There are lot of cost and benefits attached to single currency among the members, but the benefits outweigh the costs.
Criteria for OCA
Symmetric Shocks
This is in relation to the supply and demand shocks that a country faces. To fit into OCA, the states should have symmetric shocks.
High mobility in terms of labor and capital movement
The OCS members should have a free flow of workers and capitals across the region.
Flexible Prices and wages
This is relative to the Economic shocks and fluctuations, where the prices and wages should be able to change quickly as fluctuations arise.
Funds transfer and adjustment of taxation
This enables the government to maintain a central authority to transfer funds and adjust taxes to benefit the countries from each other.
Analysis of OCA
Internal and external Balances
In case a region in OCA faces an asymmetric shock, the government has the power to maintain the internal and external balances through fiscal transfers. This is done by minimizing asymmetric shocks and transfer of funds from a more earning state for welfare of the less earning state. This is not the case with countries that are not in OCA.
Monetary and Fiscal Policy
In case of countries not in OCA, the asymmetric shocks in those countries do not stabilize the situation through a single monetary policy. This has to be done through fiscal policy to control the fluctuations and shocks in those countries.
U.S. and EMU analysis as per the OCA factors
Mobility in terms of labor and capital
The labor mobility of US is higher than that of EMU
The capital mobility of both is similar
Flexible Prices and Wages
US price flexibility is similar to EMU
US wage flexibility is higher than that of EMU
Funds transfer and adjustment of Taxation
US has higher fiscal transfers than EMU
Monetary Union- Pros and Cons Discussed
Monetary union has involved a lot of cost and benefit analysis over the past for the participating countries. The most important component of such a union is Trade (Schott 1991). There are a lot of factors to be considered in understanding the pros and cons of the Monetary Union, which are discussed in detail below
Benefits of the Monetary Union
The benefits of the Monetary Union are huge in the following aspects
Exchange Rate
The formation of a union gave rise to exchange rate stability, where the trade and finance becomes independent of price changes imposed by change in exchange rates. This involves reduction in all transactional costs between member cuntries. It also allows better flow of capital and other resources among the countries.
Single Currency Benefits
The following are the benefits that are obtained through a single currency among the members of the European Union
Rise in Intra-Monetary Union Trade - The use of single currency has led to a rise in trade between all the members of the monetary union. Considering the case of Euro-zone the trade has already rose by a percentage range of 5-10 (Europa).
Price Transparency - The common currency allows consumers and organization to easily compare their prices across the region. This again helps in competition and therefore price reduction. Also, exchange rate stability among the countries will not lead to fluctuation in prices of the goods across the region.
Transaction Costs - There are no involved transactional costs to convert currencies to conduct trade or buy products from countries within the region.
Benefits of Single Market
There a lot of benefits attached to the Single market which is one of the most important components of the Monetary Union. These include
Efficient Allocation of Factors of Production-There is a free flow of factors of production among the members of the monetary Union. This has increased efficiency of production for all such countries
Benefits to Efficient Firms For efficient firms, the monetary union offers lower costs and increased profitability. This also results in increased competitiveness.
Benefits to Consumers- The increased competition leads to lower rates to consumers with more choices. Also, this has introduced newer product and market creations to overcome the cost of competition, thus additionally benefiting the needs of consumers.
Price Stability
The Central Bank of the Monetary Union might have an efficient Monetary Policy that encourages price stability, hence benefiting all the countries involved. This is the case of European Central bank that strictly imposes Price stability. This has benefited all countries whose monetary policy was not so found in terms of Price Stability.
Inflation
The inflation and Interest rates have been converged in the different countries through defined criteria like the case of EMU. The predefined elements avoid these to rise above a certain level, devising control among the monetary union.
Economic Unification
The Monetary union offers a single markets thus leading to Economic Integration and unification, refining trade among the member countries
Political integration and Stability
The Central bank has the authority to induce macroeconomic discipline on the countries that are part of the Monetary Union. This can lead to Political Integration and Stability within the countries involved.
Challenges and Costs of Monetary Unions
Apart from the benefits highlighted above, there are a lot of challenges and costs involved for the members of the Monetary Union. These are as follows
Tools of Macroeconomic adjustments
In case of monetary union like the EMU the countries tend to loose its tools of economic adjustments, these being the monetary policy and Exchange rates.
Control over Assets
The formation of a central bank incase of a Monetary union has imposed restrictions on control over assets
High unemployment rates
The introduction of monetary union has led to high unemployment rates among the member countries. This is also the case of EMU (Krugman 2010).
Monopolies
The introduction of increased competitiveness through monetary unions has made it difficult for monopolies to exist. Such organizations therefore cease to exist in countries who are member of the monetary union.
Budgetary Positions
The main challenge of a country is to not only maintain its budgetary position but gain an insight of the positions of other countries as well. This should be done as the impact of other countries could be huge incase of weaker positions.
Deficit Bias
This is the case when governments spending are more than that received. This leads to higher debts which is yet another challenge for the Monetary union, also prevailing in EMU (Mongelli 2010). There are restrictions for member countries and it is expected that over a period of time the receipts will be higher than spending hence generating revenues.
Personal Currency Representation
Incase of single currency, countries may face the requirement of their own currency representation in terms of their personalized preferences, but a single currency may not fulfill their requirement as there are a lot of countries sharing it.
Monetary Union Analysis
Time plays an important role in analyzing the costs and benefits attached to a monetary union. A few costs like that of moving towards the union and forming of a very strong body is incurred in the beginning of the union formation. The benefits attached are steady and are later on gained when the currency gains a wider acceptance throughout (Cihak Harjes Stavrev 2009). So there is a time difference between what has been invested and what is being achieved.
Also, the costs and benefits vary among countries. All the countries which participate in a union are different with their different characteristics. There is a huge impact of ones budgetary and debt position on the other, where one might be strong and other might be weak. This might be taken as the benefit for one and the challenge for other member of the union.
The financial Crisis and the Eurozone
There are concerns over the sustainability of the Eurozone as the financial crisis has also impacted this region to a very high extent. The role of the heads of governments and the European Central bank is very important to address all such issues. The union comprises of strong and weak economies and criteria which should not be abandoned incase of crisis. Therefore, it is very important that regulatory authorities plan and implement the required factors to overcome the challenges that question the sustainability of the Eurozone as a whole and all its member states.
Recession hits the Eurozone
The recent financial crisis has posed many challenges on the sustainability of the Euro zone as the crisis that started from the U.S. soon affected the European banks resulting in failure. The recession hit the euro zone in 2008, which led to serious concerns for the member states to devise plans for economic stabilization. The plan helped to support co-ordination to avoid situations where one state would benefit at the expense of the other. The most important challenge was for the European Central bank to inject money into banks (Bryant 2009).
Sovereign Debt
One of the challenges of financial crisis for few of the members was that of sovereign debt. This is related to bonds in foreign currencies that are issued by the government. This crisis took place in 2010 between members of the Euro zone.
Crisis in Greece
The crisis in Greece led to a deficit that was above the criteria of the European Union. This created a new stand for the European Union to control the overall budget deficit (Pan 2009). The development of a centralized budgetary control can maintain the deficits from stronger economies to weaker ones. Another major point to ponder was that Greece might be a medium for the speculators to attack the Euro zone.
Conclusion
The Monetary Union has posed a lot of benefits to countries that operate under the same unified umbrella. It has been analyzed that the monetary union has to some extent similarity to the optimal Currency Area but there are certain criteria that differ each from one another. The US, has been observed to fall in an OCA with all the states sharing the dollar as a single currency with higher labor mobility and wage flexibility than the European Union.
The European Union has an aim to pursue stable exchange rates. The monetary policy of the union is controlled through the European Central bank whose main aim is to maintain price stability. This leads to stability among all member nations. The members have to fit into the criteria of Price Maintenance, Inflation control, Budget Deficits, public debts, and Maintenance of Exchange rates. Since the inception of euro in 1999, 16 countries have been using it till today.
Apart from a lot of benefits of unification, there are a lot of challenges attached to joining a Monetary Union. The individual countries loose their control over assets, policies and tools for macroeconomic adjustments as these are taken care by the Unions Central Bank. Also, all the countries impact each other in terms of public debt and budgetary positions, so an insight into all this is very important. If a country has a hold on all such factors to some extent then it can reap all the benefits attached to forming a single union.
Currently, the financial crisis has posed many concerns on the Euros sustainability. The countries involved have faced challenges individually as well, where leaving the eurozone is not an option. For countries where debt is high, their credibility can only be maintained through payments in the euro and no other form of currency (MacDonald 2008). The stronger economies have also played an important part in times of crisis where they have helped in lifting the ones with weaker economies. The role of European Central Bank cannot be ignored where the survival of the Euro and its progress is due to strong hold of the Banks and Governments efforts.