Currency Exchange Rates example essay topic

It has been a long time in the making, but scheduled plans have marked January 1, 2002 as the date that the new Euro currency banknotes and coins will be introduced in Europe. July 1, 2002 is the designated day that the changeover to a monetary union will be complete. The discussion as to the risks and benefits of this monetary union has been all the talk around the world. This union will have vast and far-reaching effects that will touch not only the countries in the union, but the entire world. There will be a dramatic and radical economic change in Europe. All national currencies will disappear and there will be only one money, the European Currency Unit or ECU.

Europe economy was in shambles after the end of World War II. They had invested a lot of money and resources to financing the war. In 1948, The United States Secretary of State George C. Marshall, suggested that the United States should assist Europe in their rebuilding, restructuring, and reconstruction. Offering U.S. capital, resources, and cooperation to the countries of Europe would accomplish this. This was known as the Marshall Plan.

This plan was very successful right out of the gates. In just two years Europe was ahead in industrial production (up one hundred and thirty-eight percent) from its last year of peace before the war (Ball pg. 138). The United States continued to work with and assist Europe and in 1957, the Treaty of Rome was signed. This created the European Community (EC), or as it is otherwise known as The European Economic Community (EEC).

The premise behind this union was that if the countries of Europe were liked and dependent on each other financially, there would be less of a chance of them going to war again with each other. The European Community began with just six members. They were Belgium, Germany, France, Italy, Luxembourg, and the Netherlands. Following afterwards were the countries of Denmark, Ireland, United Kingdom Greece, Portugal, and Spain. In 1995, Austria, Finland, and Sweden became members.

All together, to this day, there are fifteen members in the EC. The purpose of the European Union was to improve cooperation between countries and remove, or at least reduce, trade and labor market barriers. In a sense, they want to create an entity very similiar to the U.S. in the fact that Americans enjoy relatively free movement of people, money, and goods. The headquarters of EU were established in Brussels. Here the EC Commission is responsible for many things such as labor, transportation, trade etc. This is very similar to the United States Cabinet (Ball pg. 139).

A council of ministers was set up to be the policy-setting body for the EU. The Prime ministers of each country meet to establish policy, which will be enforced by the commissioners. The European Parliament was established as a governing body for the European Union. Voters in each member country elect its members.

It operates as a system of checks and balances for the European Commission. It has the power to throw out all the commissioners or veto the entire EU budget. It was limited however, because in the previous powers it was all or nothing. They could not veto parts of the budget or eliminate certain commissioners. In 1987 the Single European Act gave the European Parliament some power to amend the legislation drafted by the European Commission. The EU Court of Justices was established to regulate and decide any cases that arise under the Treaty of Rome.

Its power is growing because of the high volume of cases it handles and the authority it has over the courts of the member countries. European Union has definitely become a force in world international trade. It is the largest import and export market in the world. It is second in the world to the U.S. in GDP. It also accounts for twenty percent of world trade (Ball pg. 139). The people of Europe feel that monetary union is the true key to becoming a powerful, strong, economic union.

Europeans long for an environment similar to the United States where there are little or no barriers to trade or movement of labor. Many people feel that monetary union is the only way to achieve this. Many government officials and academics have attempted proposals to move beyond monetary cooperation to monetary unification. The countries of Europe had started monetary cooperation in 1950 when the European payments union was established.

It was designed to multilateral ize trade and payments within Western Europe and provide a framework for achieving currency convertibility. (Kenen, pg. 3). Pierce Werner was appointed in 1969 to draw up a plan to make the monetary union possible. Werner was the Prime Minister and finance minister of Luxembourg.

The Werner Report scheduled monetary union to be completed by 1980. Economic crisis, rising inflation rates, and rising unemployment rates caused monetary union to be thrown off this schedule. Government officials were more concerned with their current economic situations, rather than long-term reform. In 1972 the currency snake was developed. This reduced exchange rate fluctuations by limiting the swings in bilateral exchange rates to a two and a quarter percent band (Kenen pg. 5). The snake is comprised of several European currencies, led by the German deutsche mark.

The exchange rate was agreed upon, but the value of the currencies could fluctuate up or down to a ceiling or floor exchange rate. Several currencies departed from the snake including the pound sterling, the Italian lira, and the Swedish krona. The systems inflexibility led to the demise of the snake, along with the departure of the above listed currencies. Each member country was responsible for keeping its currency value within the agreed upon relationship to the other members currencies. The agreed upon band was four and a half percent. Problems occurred because the member countries had different inflation rates, fiscal and monetary policies, and BOP balances.

Thus market pressures pushed currency exchange rates out of the agreed ranges, and the countries lacked the political will or resources to restore the agreed exchange rate. Then the currency fell out of the system (Ball pg. 165). The snake was abolished in 1973 when the world shifted to floating exchange rates. It made it more costly for some members to participate.

The snake was a kind of precursor to a stronger union that would come into being in 1979. European countries prefer fixed currency exchange rated to floating ones. The European Monetary Union was a step back to fixed rates and was a larger more improved version of the snake. This union required countries to keep their currency values within a specified range in relation to one another. The European Monetary Cooperation Fund was created to support the efforts of member countries to keep their currency values within the agreed relationship to other countries. It is comprised of dollars and gold, which have an equivalent to about thirty-two billion (Ball pg. 171).

One major difference between the EMS and the snake is that the exchange rates of the EMS are flexible. If one currency proves weaker than another does, and the governments cannot or will not take steps to correct the situation, the EMS exchange rates can be changed. There have been several rearrangements since 1979. If a snake member couldnt stay within the terms, it dropped out and ceased to be a member (Ball pg. 171).

Eight EC countries joined EMU at its onset. Italy was allowed to adopt a six- percent band, all others remained at two and a quarter percent. Spain, UK, and Portugal joined in following years at the six- percent band. In 1992 however, Italy and the UK dropped out due to the exchange rates crisis. Over the years, economic conditions had changed quite a bit from when the Werner Report was introduced. In 1989, Jacques De lors, then the president of the EC Commission, was asked to prepare a concrete outline that would lead to European Monetary Union.

This report listed three necessary conditions for monetary union. They are: the total convertibility of currencies, the complete liberalization of capital flows and full integration of financial markets, and an irrevocable locking of exchange rates (Kenen, pg. 14). He went on to say that there would be a need for a common monetary policy. This would have to be regulated by an institution that would be centralized and make collective decisions. It would influence the instruments of monetary policy such as money, credit, and interest rates.

This recommendation would serve to form the ESCB or European System of Central Banks. It would consist of a central institution and the national central banks. It would be responsible for formulating and implementing monetary policy as well as managing the community exchange rate policy vis a vis third currencies. The national central banks would be entrusted with the implementation of policies in accordance with the guidelines established by the council of the ESBC and in accordance with the instructions from the central institutions. The ESBC would have a fourfold mandate. The system would be committed to the objective of price stability.

Subject to the foregoing, the system should support the general economic policy set at the community level by the competent bodies. The system would be responsible for the formulation and implementation of monetary policy, exchange rate and reserve management, and the maintenance of a properly functioning payment system. Lastly, the system would participate in the coordination of banking supervision policies of the supervisory authorities (Kenan, pg. 14-15). De hors also stated that three steps must be taken in three domains to avoid economic imbalances. Competition policy and other measures must strengthen market mechanisms, common policies should be devised to enhance the process of resource allocation where market forces are not adequate, and macroeconomic courses should be coordinated. The report was reviewed in 1989 at the Madrid Summit.

EMU was gathering a lot of support due to the fall of the Soviet Union and the unification of Germany. Finally in 1991, EMU was put into law with the signing of the Maastricht Treaty. It provided an economic, political, and legal framework for the single currency, including three stages in the journey towards EMU. In the first stage it will be known who will be participating in EMU. The European Central Bank will be set in place and conditions for conducting monetary policies will be decided. Also the production of the Euro banknotes and coins will begin.

The second phase would bring about the start of monetary union. The rates of conversion between the Euro and the national currencies would become irrevocably fixed in early 1999, and the Euro would become a currency in its own right. The European System of Central Banks (ESCB), which groups together the European Central Bank and the participating national central banks, will then come into the picture. It will be responsible for framing and implementing the single monetary and exchange rate policy - in particular setting short-term interest rates - and any intervention vis -- vis the dollar or the yen. The participating national currencies will no longer be listed independently on the foreign exchange markets vis -- vis other currencies; their external value will be set exclusively via the Euro thanks to the irrevocable conversion rates. New issues of tradable public debt will be denominated in Euros from the beginning of this phase.

As far as the banking sector is concerned, the transition to the single currency will begin chiefly via monetary policy, the capital market and the associated settlement systems. More generally, the banks will take advantage of the time available in this phase (not more than three years) in order to inform their customers of the consequences of the switch to the single currency for their financial transactions. They will step up their staff training efforts and could also offer certain products in Euros, legal and technical constraints permitting. For example, customers' account statements could be drawn up in both national currency and Euros.

Firms could also begin operating in Euros. Companies most heavily involved in international trade are likely to opt for early conversion, although there will be no obligation to do so. Administrations will also have to prepare actively for their own changeover. They will also provide operators and consumers with the necessary information on introduction of the single currency. For the most part, however, their transactions with the public will remain in national currency until Euro banknotes and coins are put into circulation. Consumers will continue to use chiefly their own national currency because Euro banknotes and coins will not yet be available.

Public demand could, however, prompt some banks or firms to offer services in EUROs. The gradual introduction of dual pricing of goods and services will enable consumers to get used to the single currency. By developing a "feel" for prices in the single currency and learning to convert national currencies into Euros at a fixed rate, they will thus realize that they do not stand to lose from the introduction of the single currency. The third and final phase would be a definitive changeover to the Euro. By not later than January 1, 2002 and over a short period (not more than six months), the national currencies will be withdrawn and the new Euro banknotes and coins will be put into circulation.

This phase will deliberately be kept short in order to minimize the complications that would inevitably arise if national currencies were to remain in circulation for an extended period alongside the single currency. The exchanges will, of course, have been thoroughly prepared. In some cases (reprogramming of tills and cash dispensers, for example) preparations will have to be made long beforehand to ensure that software and machinery are properly adapted. Most companies are already hard at work on this in coincidence with Y 2 K preparations.

From the beginning of this phase, retailers will continue to accept national currencies but will also carry out transactions in Euros. All money-based transactions in the economy (wages and salaries, pensions, bank balances, etc.) will be denominated in Euros. References to national currencies in contracts will be converted into Euros without any other changes in terms and conditions. In other words, the principle of continuity of contracts will apply in full. Public administrations in the countries taking part in EMU will also implement a coordinated switch to the Euro for their transactions with the public. The definitive changeover to the single currency should be completed by July 1, 2002 at the latest with final withdrawal of the national currencies.

The success of the changeover to the single currency will depend on one condition: the Euro must win full public acceptance. Although the switch will indeed be a radical change and will upset people's habits, it will at the same time bring many benefits: elimination of the additional costs associated with the existence of different national currencies, enhanced price stability and transparency, simplified travel across Europe, less costly funds transfers from one country to another, but also stimulation of employment and a stronger role for Europe on the world stage. In short, the single currency will bring Europe closer to the citizen, strengthen European unity and make a genuine contribution to stability, peace and prosperity. In the long run, all the Member States of the European Union that so wish will be able to adopt the Euro once they satisfy the criteria laid down by the Treaty. Meanwhile, efforts to achieve convergence and develop solidarity between the Member States will make for greater exchange-rate stability in Europe and thus preserve the smooth functioning of the single market. In reference to the criteria mentioned above, there were five major criteria laid down by the Maastricht Treaty.

The inflation rate must be within 1.5 percentage points of the average rate of the three states with the lowest inflation. The long-term interest rate must be within two percentage points of the average rate of the three states with the lowest interest rates. The national budget deficit must be below three percent of GNP. The national debt must also not exceed sixty percent of GNP.

Lastly, the national currency must not have devalued for two years, and must have remained within the two and one quarter percent fluctuation margin provided by the EMS. A lot of people seem to think that these criteria are unrealistic for a lot of the countries of EU. Many countries will be forced to develop a cutback policy in order to fulfill the Euro requirements and become or remain a member. The members of the European Commission believe that the scenario for changeover must have certain characteristics.

First, it must allow sufficient time to win popular acceptance. Second, it must be flexible enough to allow different speeds of adjustment between currency users and to allow market forces to operate. Third, it must be efficient and not impose unnecessary costs. Fourth, it must respect the legal provisions of the Maastricht Treaty. Lastly, it must be credible and incapable of being reversed by unforeseen events. When examining EMU and the eventual joining of members to a single currency, it is important to discuss the relevant costs and benefits to the impending union.

The benefits to the European Community and to the world obviously outweigh the risks and costs or else they wouldnt be going ahead with it. There are however some issues that could be very damaging. There is a great debate as to what the effects EMU will bring to the EC and to the world. David Currie explains the debate between those who oppose and those who support in this way: The debate is polarized to an extraordinary degree.

For many who oppose the single currency, it is not merely an ill-advised undertaking, but a disastrous one: a stride further along the road to a European superstate that will submerge the individuality of the European nations in an unwieldy federation, hobbled by bureaucracy, commanding little popular support and imposing a crippling burden of regulatory and other costs on Europe's economies. Opponents also see it as a distraction from the two most urgent tasks currently facing the EU: completion of the single market and enlargement of the Union to the east. Many argue that EMU will prove unworkable and divide Europe dangerously into "ins" and "outs". Many advocates of EMU reply in kind. They see not only a chance to achieve worthwhile economic benefits, but also a fleeting opportunity to grasp an historic prize.

They regard EMU as essential to creating a stronger EU, with greater economic, political and social cohesion. This offers the best hope for helping the former communist-bloc countries: closer integration among the current EU members helps, not hinders the prospects for enlargement. Without the single currency, they say, the reality of the single market will not be achieved and Europe's economies will remain divided and weak, unable to compete internationally either with the low-wage economies of Asia or with the large, integrated, high-wage economy of the USA. Only a stronger and more integrated Europe will be able to exercise leadership on the global issues facing the world economy (Currie). Emerson points out in his book, The ECU Report, some of the benefits of EMU.

One of the most obvious benefits is the resulting ease of transactions across the EU. This will save both money and time. The savings in transaction costs would be approximately fifteen billion ECU per year, or. 4 percent of GDP. Most of these gains are financial and consist of the disappearance of bank commissions and of the exchange margin by which a bank sells a currency more expensively than it purchases it. Many also believe that the suppression of exchange rate variability in terms of increased trade and movement of capital will do much to lessen foreign exchange risk.

A potentially very important gain arises because EMU reduces the overall uncertainty which investors feel about economic prospects, particularly foreign investors faced not only with the inherent risk of a particular project but also with the risk that an exchange rate change may wipe out the value of future profits. A reduction in overall uncertainty could lower the risk premiums firms have to pay to raise equity capital and would greatly increase investment. Even a small reduction in the risk premium could raise the income of the community significantly. By improving business expectations of future growth and profits, EMU could lead the community not just to a rise in income, but to a higher annual growth path.

This would also cut unemployment substantially (pg. 33). Currie discusses in his article the advantages of low inflation that monetary union will bring. For many proponents of EMU, the most important economic advantage is the prospect that the independent European Central Bank (ECB) will deliver durably low inflation for the EMU area. For Germany, which has enjoyed low inflation for decades, the ECB can scarcely offer more on this front than the status quo. These reservations probably apply also to those countries, such as Austria, France and the Netherlands, that have attached their currency to the D-mark and hence adopted the Bundesbank as their de facto central bank. For them, however, the creation of the ECB offers a voice in the conduct of monetary policy, which they currently lack.

The disinflation benefits will plainly be greatest for EMU countries that have not enjoyed stable low inflation hitherto. These include Ireland and the UK (were it to join) together with Italy, Portugal and Spain. Low inflation implies low interest rates, as the premiums for inflation and exchange-rate risk would be eliminated from interest rates. Despite the independence of the Bank of England, the UK still faces a premium of more than 1% on long-term borrowing rates compared to Germany and France.

Three factors could, however, make the ECB's performance somewhat more erratic than the Bundesbank's. First, governors of central banks from all participating countries will influence the ECB's decisions on interest rates. Although the Maastricht Treaty safeguards the ECB's independence, it is legitimate to ask at what level of pressure their political resolve might buckle, for example if unemployment remained very high. Second, unlike the Bundesbank, the ECB has a reputation to establish, and to start with a period of higher interest rates may be needed to demonstrate anti-inflation resolve. This in turn could reinforce internal dissent in the ECB. Third, EMU will be a profound economic change, which may well alter the workings of the joint monetary economy in significant and unpredictable ways.

All central banks have to cope with such changes from time to time: examples include the shift in UK demand for money after financial markets were liberalized in the 1980's. At such times, policymakers can lose their bearings, and the conduct of monetary policy can become volatile. The ECB will enjoy the monetary equivalent of a baptism of fire. On balance, it seems likely that the ECB will be able to establish a record and reputation for conducting monetary policy in a sound manner. But this may take time, and in the meantime Euro monetary policy, and the markets' judgement of it, may prove erratic. These problems could be particularly acute if EMU starts on weak foundations, with insufficient convergence...

German exporters will no longer be at a disadvantage vis -- vis their European competitors in the European internal market and in the markets of non-EU states as a result of devaluation of their competitors' currencies. Companies will have a reliable basis on which to plan; tourists will not have to exchange currency, which means their holidays will be cheaper; the European currency can become a more important world reserve currency than is presently t he case; and competition intensified by greater transparency in prices will improve the efficiency of the European economies. This will make it possible to safeguard present jobs and create new ones (Currie). Despite all of these benefits, there are still concerns about EMU.

For one there is a huge cost involved in switching to a single currency. For one, new money has to be made. Adjustments will have to be made to all the different types of money machine such as ATMs, soda machines, and subways. It is estimated that these costs alone will total over five billion.

Other major roadblocks are the major cultural differences and the extreme sense of nationalism that each country has There are huge differences in labor market institutions within Europe. There is a language barrier between almost every country in the union. There are differences in opinion in regard to policies, laws, government, and regulations. It will be interesting to see if all the countries of EC can work together for the mutual benefit of the community. There also may be discrimination occur between the countries of EU and non-EU countries. Currie describes in his article how the "ins" could discriminate against the "outs" by exploiting loopholes in existing single market directives, devising forms of market opening in new, currently closed areas (for example, European gas and electricity markets), or, in the financial area, by claiming that the interests of EMU monetary policy are paramount.

(This last is a tactic that the likely participants in EMU have already used over access to Target, the financial settlement system for Euros.) Or they may simply fail to represent the interests of the "outs" as strongly and negotiations often arrive at a balancing of national interests. Finally they may simply flout the rules: by the time that companies or governments have been to the European court, commercial damage may already have been done (Currie). Currie surmises: With the right policies, Europe could become an economic powerhouse. Without them, it will continue to decline and lose out to other parts of the world, notably Asia. Moreover, the EU must also face the need to open to the eastern part of Europe, to avoid the political and social unrest that will otherwise result. Getting these policies right will not be easy.

If EMU proceeds, the lack of exchange-rate flexibility will mean that regional unemployment and industrial balance will emerge as even more important policy issues than hitherto. The future of the EU will depend on its capacity to address these fundamental issues. Much will depend on whether there are European leaders in the next decade with the right strategic vision for Europe and the capacity to realize it. But that requires a vigorous and informed public debate so that these crucial issues are at the forefront of European politics.

Europe faces momentous developments over the next few years and in the first decade of the next century. EMU is a risky venture: ensuring that it works well will be fundamental to the future prosperity of the region and the well being of its people (Currie). The Euro, for better or worse, will become a reality and irreversible truth by July of 2002. Thirteen billion banknotes are in production in denominations of 5, 10, 20, 50,100,200, and 500. Euro coins will be produced in denominations of. 01, .

02, . 05, . 10, . 20, . 50, 1, and 2. Their initial amount will total seventy billion.

It has been a long road for monetary union in Europe, but the everlasting benefits that union could produce for the people may be well worth the wait. One will just have to wait and see. Ball, Don. International Business, The Challenge of Global Competition. Boston: Irwin McGraw-Hill., 1999. Currie, David.

The Pros and Cons of EMU. 1998. URL: web 1999. De Grau we, Paul.

The Economics of Monetary Integration. New York: Oxford University Press., 1997. Emerson, Michael. The ECU Report. London: Pan Books Limited., 1991. Kenen, Peter.

Economic and Monetary Union in Europe. New York: Cambridge University Press., 1995.