1. A2 Economics
PowerPoint Briefings 2009
The Single
European
Currency
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2. Key Issues
• Which countries have joined the Euro Zone?
• Why have convergence criteria?
• What are the basic effects of a single currency?
• What are the motivations for joining the Euro?
• The case for UK entry
• The case against UK entry
• Optimal currency areas
• Tensions for the single currency in 2009-2010
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3. Britain and the Euro – The Current
Position (2009)
• Britain is outside of the Euro Zone
• It has an opt out from the single currency
• No entry likely in the coming years
• Important point: Even though the UK is outside of the
Euro Zone, the UK cannot be isolated from the static
and dynamic effects of the Single European
Currency
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4. Back to Basics on the Euro
• A single currency requires a common interest
rate for the Euro Zone – i.e. a common
monetary policy
• 16 member nations are inside the Euro Area
• The European Central Bank (ECB) sets official
interest rates to meet an inflation target of 2%
• The approach of ECB is different to that of the
USA Federal Reserve (dual target)
• The US Federal Reserve tends to set interest
rates to maintain growth and avoid deflation
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5. Central Bankers
Bernard Mervyn King Jean-Claude
Bernanke Trichet
Governor of the
Chairman of the Bank of President of the
Federal England European
Reserve Central Bank
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6. Euro Zone Interest Rates
Interest Rates for the Euro Area and for the UK
Per Cent
8.0 8.0
Bank of England Rates
7.0 7.0
6.0 6.0
5.0 5.0
Percent
4.0 4.0
3.0 3.0
2.0 2.0
Euro Zone Interest Rates
1.0 1.0
0.0 0.0
99 00 01 02 03 04 05 06 07 08 09
Source: Reuters EcoWin
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7. Judging the Success of the Euro
• The Euro project should be judged according
to whether it achieves its long term aims
– (1) Sustained non-inflationary growth
– (2) Lower long-term interest rates and
higher rates of investment
– (3) Lower unemployment
– (4) Expansion of the EU single market
• The Euro on its own in insufficient to achieve
these – structural economic reforms in Europe
are also required and many are taking place
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8. Convergence Criteria – Joining the Euro
• Flexibly applied for original Euro members – but more strictly
applied in the case of new member states
• Inflation:
– Average inflation over previous year must not exceed by
more than 1.5% that of the three lowest inflation countries
• Government Finances
– Budget deficit must not exceed 3% of GDP
– Gross government debt must not exceed 60% of GDP
• Interest Rates:
– Average yield on govt bonds must not exceed by more than
2% bond yields of three lowest inflation countries
• Exchange Rate Stability:
– Currency must have adhered to fluctuation margins of the
ERM II in two previous years without severe tension
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9. Inflation AnnualRepublicchange in – Slovakia
convergence the consumer price index
Slovak
percentage
- Consumer Price Inflation
18.0 18.0
16.0 16.0
14.0 14.0
12.0 12.0
10.0 10.0
Percent
8.0 8.0
6.0 6.0
4.0 4.0
2.0 2.0
0.0 0.0
99 00 01 02 03 04 05 06 07 08
Slovak Republic Euro Zone
Source: Reuters EcoWin
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10. Nominal v Real (Structural) Convergence
Nominal Economic Indicators
• (Those required under the
Maastricht Treaty)
• Consumer price inflation
• Short term interest rates
• Fiscal (Budget) deficit
• Gross government debt
• Exchange rate stability
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11. Nominal v Real (Structural) Convergence
Nominal Economic Indicators Real Economic Indicators
• (Those required under the • (Important in the long term)
Maastricht Treaty) • Trend growth of GDP
• Consumer price inflation • Labour market
• Short term interest rates performance
• Fiscal (Budget) deficit • Trend growth of labour
• Gross government debt productivity
• Trade balances in goods
• Exchange rate stability
and services
• Investment/GDP ratios
• Housing market structure
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12. A2 Economics
PowerPoint Briefings 2009
Optimal Currency Areas (OCA)
Is the Euro Zone an optimal
currency area?

13. Is the Euro an Optimal Currency Zone?
• An optimal currency zone occurs when:
– (1) Countries have achieved real convergence
– (2) They respond in similar ways to external economic
shocks or macro policy changes
– (3) They have sufficient flexibility in both their product
markets and labour markets to deal with these shocks
• High geographical mobility of labour
• High occupational mobility of labour
• Wage and price flexibility in factor markets
– (4) Countries are prepared to use fiscal transfers to
even out some of the regional economic imbalances
within the European currency union
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14. Optimal Currency Zones (2)
• By most criteria, the current Euro Zone
does not come close to an optimal
currency zone!
– The core group of EU countries are broadly
similar (Germany + France + Netherlands +
Belgium)
– But peripheral countries have big structural
differences
– And there are barriers to the mobility of labour
– Little wonder that tensions are rising in the
Euro Area as recession bites
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15. Optimal Currency Zones
Highly
Flexible
Labour
Market
Flexibility
Inflexible
Divergent Real Economic Convergent
Convergence
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16. Optimal Currency Zones
Highly
Flexible
Labour
Market
Flexibility
High risk
currency union
Inflexible
Divergent Real Economic Convergent
Convergence
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17. Optimal Currency Zones
Highly Monetary Union
Flexible Works
Labour
Market
Flexibility
High risk
currency union
Inflexible
Divergent Real Economic Convergent
Convergence
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18. Is the Euro an Optimal Currency Zone?
Professor Robert Mundell
The 1999 Nobel Prize Winner
"for his analysis of monetary
and fiscal policy under
different exchange rate
regimes and his analysis of
optimum currency areas"
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19. Tensions in the Euro Area (2)
• Recession in Euro Area as a whole (-2% in 2009)
• Riots and protests
– Fears of deep cuts in real wages
– Rising unemployment
– Strong Euro making life very tough for exporters
– Many peripheral Euro Area countries are struggling
e.g. Greece, Ireland, Italy, Portugal and Spain
– Huge divergence in competitiveness showing up in
massive trade imbalances
– But no chance of nominal exchange rate adjustment
– So downward pressure on wages and jobs
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20. Tensions in the Euro Area (1)
• Fiscal policy is coming under pressure:
– Bail outs for financial institutions
– But smaller EU states have little chance of doing this
– Cross-border contamination e.g. heavy investment into CEEC’s by
Austrian banks (a study predicts a tripling of trade between Central
and Eastern European countries over the next ten years, similar to
the evolution of trade between Spain and Portugal after they joined
the European Economic Community.
– Downgrading of credit rating for several Euro Area countries
including Spain and Greece
– Makes it more expensive for companies and the government to
finance borrowing
– Think of consequences for investment and growth
What happens if one or more countries leave and devalue their way to
an economic recovery?
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21. A2 Economics
PowerPoint Briefings 2009
Case for Entry into the Euro

22. Microeconomic Benefits of Entry
• The Euro is important in realising some of the gains
from a functioning single market
• (1) Potential Gains for consumers
– Lower prices because of increased competition/
greater price transparency (this is more likely
with easily transportable goods)
– Reduction in the transactions costs of travelling
within Europe (e.g. costs of currency
exchange)
– Easier to live and work in different EU countries
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23. Microeconomic Benefits of UK Entry
(2) Potential gains for businesses
• Invoicing can be done with one currency
• Lower transactions costs – some
people argue that staying out of the Euro
is equivalent to exporters facing a tariff
when they trade inside the EU
• Gains for the tourist industry in
attracting overseas visitors
• Businesses might be able to fund their
capital investment at lower real interest
rates
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24. A2 Economics
PowerPoint Briefings 2009
The Case for Staying Outside the
Euro Zone

25. Microeconomic Disadvantages
(1) Changeover Costs from joining the Euro:
– Costs of changing accounting systems
– Menu Costs (vending machines, catalogues,
franking machines, postage
– Installation of new payments systems
– Customer confusion (imperfect information)
(2) Higher prices
– Potential loss of consumer welfare if suppliers
increase prices when converting from sterling to euro
(3) The vast majority of consumers will continue to buy
locally – what matters more is the effectiveness of
competition policy in targeting anti-competitive
behaviour
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26. Macroeconomic Case Against Entry
(1) Entering the Euro means losing an instrument of
policy adjustment
– A “one-size fits all” monetary policy may work
against a country if their cycle is not convergent
with Euro Zone
– Retaining the option of making an exchange rate
adjustment is useful
(2) Fiscal Policy constraints
– The EU Growth and Fiscal Stability Pact
– Limits on government borrowing
– But now largely ignored – especially with the effects
of the credit crunch / fiscal bail-outs etc
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27. Expansion of the Euro Zone
• Slovenia joined in 2007
• Cyprus and Malta joined in January 2008
• Slovakia joined in January 2009
• Latvia narrowly missed out on the convergence
criteria
• Other countries have delayed their entry
• What are the arguments for the new member
states entering the single currency?
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28. Converging on the Euro Area
Official Policy Interest Rates
per cent
9 9
8 8
7 7
6 6
5 5
%
4 4
3 3
2 2
1 1
0 0
01 02 03 04 05 06 07 08
Slovak Republic Eurozone
Source: Reuters EcoWin
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29. Fixing the currency ahead of the switch
Slovakian Krona against the Euro
Krona per Euro
40 40
39 39
38 38
37 37
36 36
EUR/SKK
35 35
34 34
33 33
32 32
31 31
30 30
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan
05 06 07 08 09
Source: Reuters EcoWin
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