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Chapter 20
Chapter 20
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Preview
! The European Union ! The European Monetary System ! Policies of the EU and the EMS ! Theory of optimal currency areas ! Is the EU an optimal currency area? ! Other considerations of an economic and monetary union
Copyright 2012 Pearson Addison-Wesley. All rights reserved.
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Membership of the EU
! To be a member of the EU, a country must, among other things,
1.! have low barriers that limit trade and flows of financial assets 2.! adopt common rules for emigration and immigration to ease the movement of people 3.! establish common workplace safety and consumer protection rules 4.! establish certain political and legal institutions that are consistent with the EUs definition of liberal democracy.
Copyright 2012 Pearson Addison-Wesley. All rights reserved.
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! A credit system was also developed among EMS members to lend to countries that needed assets and currencies that were in high demand in the foreign exchange markets.
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Fig. 20-2: Inflation Convergence for Six Original EMS Members, 19782009
Source: CPI inflation rates from International Monetary Fund, International Financial Statistics.
Copyright 2012 Pearson Addison-Wesley. All rights reserved.
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! The Maastricht Treaty, proposed in 1991, required the 3 provisions to transform the EMS into an economic and monetary union.
! It also required standardizing regulations and centralizing foreign and defense policies among EU countries. ! Some EU/EMS members have not ratified all of the clauses.
Copyright 2012 Pearson Addison-Wesley. All rights reserved.
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1.! attain exchange rate stability defined by the ERM before adopting the euro. 2.! attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest national inflation rates among EU members. 3.! maintain a restrictive fiscal policy:
! ! a maximum ratio of government deficit to GDP of 3%. a maximum ratio of government debt to GDP of 60%.
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The Stability and Growth Pact, negotiated in 1997, also allows for financial penalties on countries with excessive deficits or debt.
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! we have assumed that a new member would be fully committed to a fixed exchange rate system.
! But if a new member is likely to leave the fixed exchange rate system, then joining the system would not reduce uncertainty (as much).
Copyright 2012 Pearson Addison-Wesley. All rights reserved.
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Consider what would have happened if the country did not join the fixed exchange rate system:
! the automatic adjustment would have caused a depreciation of the domestic currency and an appreciation of foreign currencies, which would have caused an increase in many prices for domestic consumers when goods and services markets are integrated.
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! Was trade restricted by regulations that were removed under the Single European Act?
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Table 20-2: People Changing Region of Residence in the 1990s (percent of total population)
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APPLICATION
Optimum Currency Areas: Europe versus the United States !
OCA Criteria for Europe and the United States (continued) ! Data in panel (c) show that U.S. labor markets are very integrated compared with those of the EU. !
APPLICATION
Optimum Currency Areas: Europe versus the United States !
OCA Criteria for Europe and the United States Most economists believe that the United States is much more likely to satisfy the OCA criteria than the EU is. Why? ! Data in panel (a) show that interregional trade in the United States rises to levels much higher than those seen among EU countries. !
APPLICATION
Optimum Currency Areas: Europe versus the United States !
OCA Criteria for Europe and the United States (continued) ! Data in panel (b) show that U.S. and EU shocks are comparably symmetric. !
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Source: Datastream.
Copyright 2012 Pearson Addison-Wesley. All rights reserved.
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Table 20-3: Current Account Balances of Euro Zone Countries, 20052009 (percent of GDP)
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Other Considerations for an EMU (cont.) ! The amount of transfers among the EU members may also affect how EU economies respond to aggregate demand shocks.
! Fiscal payments between countries in the EUs federal system, or fiscal federalism, may help offset the economic stability loss from joining an economic and monetary union. ! But relative to interregional transfers in the U.S., little fiscal federalism occurs among EU members.
Copyright 2012 Pearson Addison-Wesley. All rights reserved.
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Summary
1.! The EMS was first a system of fixed exchange rates but later developed into a more extensive coordination of economic and monetary policies: an economic and monetary union. 2.! The Single European Act of 1986 recommended that EU members remove barriers to trade, capital flows, and immigration by the end of 1992.
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Summary (cont.)
3.! The Maastricht Treaty outlined 3 requirements for the EMS to become an economic and monetary union.
! ! It also standardized many regulations and gave the EU institutions more control over defense policies. It also set up penalties for spendthrift EMU members.
4.! A new exchange rate mechanism was defined in 1999 vis--vis the euro, when the euro came into existence.
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Summary (cont.)
5.! An optimum currency area is a union of countries with a high degree of economic integration among goods and services, financial assets, and labor markets.
! It is an area where the monetary efficiency gain of joining a fixed exchange rate system is at least as large as the economic stability loss.
6.! The EU does not have a large degree of labor mobility due to differences in culture and due to unionization and regulation. 7.! The EU is not an optimum currency area.
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