Its Exchange Rate And Monetary Policy example essay topic

The building of a United Europe is undoubtedly one of the greatest historical undertakings of the 20th century. It is a process grounded in the positive values with which our civilization identifies - the preservation of peace, economic and social progress, respect for the person and the predominance of right over might - and, over nearly 50 years for which the process has been under way, there have been some moments of crisis but also major successes. Six countries originally rallied to the concept of a united Europe; now there are fifteen, while more than ten others feel drawn to towards the ideal and have applied to join the European Union. The Birth of the European Monetary System The economic crisis of the 1970's led to the first plans for a single currency. The system of fixed exchange rates attached to the US dollar was abandoned. European leaders agreed to create a "currency rope", tying together European currencies.

Maastricht Treaty In December of 1991 the 15 members of the European Union, meeting in the Dutch town of Maastricht, agreed to set up a single currency as part of a drive towards Economic and Monetary Union. There were strict criteria for joining, including targets for inflation, interest rates and budget deficits. A European Central Bank was established to set interest rates. Price stability was identified as the paramount goal of the European Central Bank's monetary policy.

To Enter the Euro-zone, a country must satisfy Convergence Criteria that are the following: . Low inflation. Low long-term interest rates. Stable exchange rate. Small budget deficit (less than 3% of GDP). National debt cannot exceed 60% of GDP The analysis of our case centers around the following questions: 1, Why did members of the EC create the European Monetary System (EMS)?

The EMS was crated in 1979 to stabilize foreign exchange and counter inflation among members. It was formed on the initiative of France and Germany for two reasons: O To defend Europe's economic interest more effectively on the world stage O Also, due to an ambition to achieve greater economic unity among members. A, Why did France bother to join? France had long been the leading advocate of a centralized and independent monetary institution. The country joined to gain credibility from an institution modeled on the Bundesbank of Germany. The Bundesbank of Germany had a renown reputation as an inflation fighter.

B, Was this an easy sell? The idea for an EMS was not an easy sell. The EMS worked for a while and then fell apart. This led to the creation of the European Monetary Union (EMU) in 1989. The EMU was formed as the EMU members came to realize that a single EU currency will provide greater degree of European market integration than fixed rate by removing the threat of EMS currency re-alignments and eliminate costs to traders in the EU of converting one EMS currency to another.

Some EU leaders also thought Germany's management of the EMS monetary policy was biased as it placed a one-sided emphasis on Germany's macro-economic goals at the expense of EMS partners. C, How do you convince less prosperous countries to join? You convince them to join by showing that the benefit of joining a fixed exchange rate area out weighs the cost. A major benefit of joining a fixed exchange rate is that they simplify economic calculations and provide a more predictable basis for decisions that involve international transactions than do floating rates.

This advantage is known "monetary efficiency gain". One of the costs of joining an exchange rate area is that the country gives up the ability to use its exchange rate and monetary policy for stabilizing output and employment. 2, How well did the EMS work? The EMS was made to stabilize exchange rate and reduce inflation by limiting the margin of fluctuation for each member currency to a small noticeable difference that is acceptable from a central rate. A common European Currency Unit (ECU) was introduced by which the central exchange rates could be set. The European Currency Unit consists of all the European Union Currencies weighted according to the economic importance of each country.

When any currency reaches the limit of the margin fluctuation, which is set at 2.25 percent, the central banks of the respective countries must intervene by selling off the stronger currency and buying the weaker one. This helped to stabilize the currency from dropping too low by decreasing the amount of it on the open market. The European Monetary System also required member governments to take appropriate economic policy steps to prevent continued deviation from the central rate. The EMS helped lower inflation rates in the European Community and eased the economic shock of global currency fluctuations during the 1980's. Between 1979 and 1981 parities within the European Monetary System remained in relative good shape. Two years of stability was a stun to member states, who anticipated sharp tension among members would occur because of fear that Germany may adopt restrictive monetary policy and stronger currency.

In late 1979, the German mark appreciated against the group member states and was realigned. Also in the late seventies, the German economy was booming when the oil shock hit. Oil prices rose sharply and this led to a rise in import costs and sent the German trade account into a deficit. Furthermore, the German economy lost momentum when the U. S Federal Reserve initiated its high interest rate policy. These events weakened the German Mark and in fact relieved pressure on the EMS. In 1981, France elected a socialist president and a socialist majority to the National Assembly.

The new government increased expenditures on housing, family allowances, health benefits, and increased minimum wages. These policies improved economic growth in the short run, while major trading partners in Europe were in recession. In 1981-82 French prices rose by 12.6% compared with 4.4% for Germany. France's balance of trade fell sharply into deficit, and severe downward pressure mounted against the franc. Despite realignments of the franc in 1981 and 1982, France's current account deficit, inflation rate, and exchange rate all continued to deteriorate. France was under pressure to protect its position in the European Monetary System.

The government adopted hard economic measures. Taxes were raised and public spending was cut. The government adopted tough policies because it did not want to weaken the European community. In fact, if France had withdrawn from the European Monetary System, the franc would have lost its value because the French central bank would not be able to stop the pressure on the franc. The European Monetary System didn't reach "phase two" of the creation of the European Monetary Fund, because Germany feared that the European Monetary Fund would limit its ability to shape national monetary policy and the other members questioned the value of a European Monetary Fund.

The European Monetary System countries had achieved exchange rate stability and some unification in national monetary policy. Nonetheless, wide differences in fiscal policies and national economic performance persisted among European Community countries. So overall the EMS worked fairly well in the early years of its formation but fell apart a few years after its formation. 3, What are the forces working for and against the creation of a European Central Bank? The European Central Bank (ECB) is the pivot of the Euro system.

It guarantees that the tasks delegated to it are performed either by its self or via the participating national central banks. In pursuit of its primary objective, price stability, the ECB's main missions are to: O Define and implement the monetary policy of the euro zone; O Conduct foreign exchange operations, hold and manage the official exchange reserves of the countries of the euro zone; O Issue notes in the zone euro; O Promote the smooth operation of payment systems. Advantages of the ECB: O Elimination of foreign exchange transactions costs with other euro-zone countries. O Elimination of exchange rate uncertainty of each country's currency against the euro, which should improve the quality of information on which consumers and firms base their decisions. O Greater price transparency when all goods are priced in euros may lead to increased competition in the Single Market. O Participation in integrated market-based European financial markets as the result of the elimination of currency risk.

This Leads to a more efficient European financial market. Disadvantages of having the ECB: O The country can no longer conduct monetary policy on its own behalf. O The country may have to substantially limit its use of expansionary fiscal policy under the Stability and Growth Pact. O The ECB must keep inflation in check, and contributes to economic efficiency in order to show credibility of the central bank. O The exchange rate is no longer available to cushion "asymmetric shocks O Pursue the main objective of the Euro system in maintain price stability in the euro zone, thus preserving the euros purchasing power. A, Is EMU desirable?

The adoption of a common monetary policy in Europe eliminated the possibility to use monetary policy for the stabilization of country-specific shocks. This is generally considered as the main cost of forming a monetary union. As monetary policy can no longer address country-specific shocks other solutions need to be found. One possibility would be the adoption of a system of cross-border fiscal transfers to countries hit by exceptionally bad shocks. Another solution instrument in the hands of national authorities capable to stabilize local macroeconomic conditions is fiscal policy. B, Is the EMU feasible?

In order to bolster its monetary union with democratic legitimacy, it needs to develop a fully-fledged political system. The present system - is a European Union that makes monetary and economic decisions with far-reaching impact on the daily lives of citizens, but at the same time it lacks electoral parliamentary legitimacy creating a democracy gap that is not sustainable in the long run. Therefore, the temptation for Europe is to find the motion to build more or less a federated, political entity closing the democracy gap. The constitutional convention basically needs to achieve two major objectives in order to reform the EU into a political union. A transparent and efficient vertical sharing of power between the EU and its member states and a horizontal sharing of powers between the three EU-institutions - the Commission, the Council, and the European Parliament.

The EU has tried to reform its institutional set-up ever since the Treaty of Maastricht, which set up EMU without achieving political union. The struggle between an intergovernmental approach and a more "federal" approach has endured for more than a decade now. C, Is EMU unavoidable? Given the facts presented before us and the important role that they play in order to ensure that the requirements are met, for example the 2% inflation rate. I would have to say that The EMU is not unavoidable. D, IS European Monetary Union (EMU) unavoidable?

The quest for European monetary unification became a reality on January 1, 1999, by the introduction of a common currency, the euro, the establishment of common tariff, the reduction of interest rate and inflation, and the creation of a central bank. The road leading to this day has been momentous and challenging due to the history of Europe and the political establishment who has been longing for a currency to counter the effect of the US dollar in the foreign market. By 1985 Europe had seen a temporary upswing economic, which led to the drive for the EMU to expand memberships to 15 countries and developed common monetary and fiscal policy toward GDP such as low interest rate and inflation. In addition, supporters of the EMU believe that any country located near the euro block will find economically advantageous to become a member. Other argues, that EMU will generate better macroeconomic performance and other economic gains for it members such as major labor market reform and agricultural reform. Even countries are waiting for their membership seen to find the EMU or the euro unavoidable.

Today Country such as Greece, Turkey, the former Soviet's States even England want to be a member because of it market value share. One reason is that EMU creates a market of close to 300 million consumers serve by a common currency, 10% more than the US. On the other hand country such as Britain at the beginning, which has been an advocate against the EMU for fear of lost of economic sovereignty, is so wary of the idea that it has not joined the euro. D, How necessary are budget controls?

By the 1990's Europe saw a rise in public debt, inflation and unemployment, which has forced most government to expand public employment and interest rate. The increase in unemployment rates led to a large and constant budgetary drains. First, Finland, France and Germany have reduced both categories of government consumption, although simultaneously taxes have been risen and capital outlays. Second, wage payment has actually risen in France, but public finances benefited from falling interest rates. Third, to offset increase in social benefit and interest payment they have mainly raised taxed. Other countries have so far benefited from lower interest rates, but they have to follow a rigid monetary and fiscal policy.

Nevertheless, some countries might be deterred from fiscal expansion by the fear of appreciating their currencies. However, it is not surprising that some countries are finding it difficult to meet the requirements of EMU. "Fiscal tightening in preparation for EMU has tended to raise unemployment and thus benefit payment, leaving a diminished net positive effect on government budgets. Countries where unemployment has come down since the 90's (Finland, the Netherlands, and Ireland) are in relatively good fiscal shape.

Countries, where unemployment is high and rising (France, Italy, Germany), are having a hard time adjusting" (1). High unemployment couple with the rigid monetary policy such as such reducing inflation by 1.5% and reducing the government's budget deficit to no more than 3% of GDP makes budget control difficult to attain in those countries (See chart and Graph in appendix). France and Germany were the countries that were hit the most countries. E, Why did the EC find it easier to create a common market in goods than in currencies? Post the Second World War European's leaders envisioned a globalize economy and further enlargement of the union to counter the position of US dollar. The effect of exchange rate and the monetary autonomy made no differences between markets.

By 1989 Mr. Delors head of the ECU presented the three stages leading to the EBC and the operation of the euro. "Germany served as the anchor state much as the US did in the Breton Woods system... The Delors Report raises the question of fiscal independence" (2). The Bundesbank became the leading contender of the EBC. Germany envisioned and designed the ECB as a replica of the Bundesbank because of it volume and it place in the world.

For instance Germany's politic dominate the EMS. They set interest rates to suit its own economy, and most other Europeans were then obliged to adapt. In 1979, due to the inflexibility of the EMU the community "adopted the snake an exchange rate agreement requiring fluctuations of no more than +/- 2.25% against the dollar in the currencies of both the member states and some countries that had not yet acceded to the community" (3). F, Will Economic integration drive political integration?

Unlike the US, Europe is not a coherent continent. For the first time Europe's small states see the EU as a guarantee that the continent will be run by law rather than force or military. Each member has the same voting right unlike the United Nation. As the tension between big and small countries emerge, the smaller state see the EU contemplates how to run itself in the future. The head of each country's central bank has an equal voice in making European monetary policy; the governor of Germany's Bundesbank, for instance, has no more say than the governor of Greece's central bank. Franco-German Alliance was the center stage for the collapse of EMS.

Smaller states fear the their alliance and they will lose control over the vision of the group. By 1979, Germany " accounted for the bulk of the group's GDP and the only significant world currency. The Bundesbank was proving itself the economic power in Europe a chastening realization France which had longing itself the senior member of the Franco-German partnership" (4) 4, What are the economic implications outside of Europe One of the most obvious implications of the start of EMU for the United States -- as well as for the world community -- was the coming into existence of a new currency, the euro, which is intended to function as a major international currency alongside the U.S. dollar. It is quite true that the euro may quickly become the currency of choice in the invoicing of trade between companies in the European Union and their foreign counterparts. Companies in regions with strong links to the European Union, such as those in eastern and central Europe, North Africa, and the CFA French franc zone, may also choose to invoice trade in euros. More generally, the euro may well expand its importance in world trade beyond the relative trade weight of the European Union countries, following a path similar to that taken The economic effects of these potential changes in invoicing practices are likely to be limited.

The re-denomination of a significant share of world trade into euros will mainly represent a shift in invoicing practices from the use of former European currencies to euros. The current role of the dollar should not be taken for granted. Once the euro comes into existence, the simple conversion of the EMU countries' outstanding securities into euros will contribute to the immediate creation of a major securities market. This development alone will create a critical mass for a market in euro-denominated securities. It will bring down the costs of conducting transactions, issuing loans, and trading securities below those currently seen for European national currencies -- possibly to levels comparable to those for dollars. Since banks are the main intermediaries of cross-border transactions, the banking sector will bear the brunt of the costs associated with the changeover to a common currency.

At the same time, however, the larger single market will create new opportunities for banks, particularly in the areas of investment banking and the cross-border sale of deposits, mutual funds, and other savings products. Moreover, a well-developed market for euro-denominated capital would encourage institutional investors from the United States and elsewhere to acquire diversified European portfolios offered in a single currency. EMU may cause a short-run glut of dollars in the international capital markets, leading the dollar to depreciate and the euro to appreciate, with resulting undesirable effects on trade flows. The reason there could be a dollar glut, is that EMU would eliminate the need for intra-European intervention, reduce the importance of exchange rate management, and allow national central banks to pool reserves for external intervention, thus generally reducing the European central bank's need for dollar reserves. But should a different international monetary system ultimately emerge in which other currencies, such as the euro, play an increasingly important role alongside the dollar, there would be benefits for the United States as well. A common U.S. currency, it is important to note, has many advantages beyond simply reducing transaction costs.

It also simplifies choices for households and corporate management, enhances the efficiency with which financial institutions and the payments system function, and promotes competition across the whole productive spectrum..