Microsoft PowerPoint – C21_ECON7520_week11
Chapter 21
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Optimum Currency Areas and the Euro
Instructor:
Learning Objectives (1 of 2)
21.1 Discuss why Europeans have long sought to stabilize
their mutual exchange rates while floating against the U.S.
21.2 Describe how the European Union, through the
Maastricht Treaty of 1991, placed itself on the road to
having a single currency, the euro, issued and managed by
a European Central Bank (ECB).
21.3 Detail the structure of the ECB, the European System
of Central Banks, and the European Union’s arrangements
for coordinating member states’ economic policies.
Learning Objectives (2 of 2)
21.4 Articulate the main lessons of the theory of optimum
currency areas.
21.5 Recount how the 19 countries using the euro have
fared so far in their currency union, and the steps they are
taking in response to their prolonged economic crisis.
• 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
What Is the EU?
• The European Union is a system of international institutions, the first
of which originated in 1957, which now represents 27 European
countries through the following bodies:
– European Parliament: elected by citizens of member countries
– Council of the European Union: appointed by governments
of the member countries
– European Commission: executive body
– Court of Justice: interprets EU law
– European Central Bank, which conducts monetary policy
through a system of member country banks called the European
System of Central Banks
What Is the EMS?
• The European Monetary System was originally a
system of fixed exchange rates implemented in 1979
through an exchange rate mechanism (ERM).
• The EMS has since developed into an economic and
monetary union (EMU), a more extensive system of
coordinated economic and monetary policies.
– The EMU has replaced the exchange rate mechanism
for most members with a common currency under the
economic and monetary union.
Membership of the Economic and
Monetary Union
• To be part of the economic and monetary union, EMS
members must
1. adhere to the ERM: exchange rates were fixed in
specified bands around a target exchange rate.
2. follow restrained fiscal and monetary policies as
determined by Council of the European Union and the
European Central Bank.
3. replace the national currency with the euro, whose
circulation is determined by the European System of
Central Banks.
Membership of the EU
• To be a member of the EU, a country must, among other
1. have low barriers that limit trade and flows of financial
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 E U’s definition of liberal
democracy.
Figure 21.1 Members of the Euro Zone as
of January 1, 2021
The heavily shaded countries on
the map are the 19 members of
EMU: Austria, Belgium, Cyprus,
Estonia, Finland, France,
Germany, Greece, Ireland, Italy,
Latvia, Lithuania, Luxembourg,
Malta, the Netherlands, Portugal,
the Slovak Republic, Slovenia,
and Spain. The United Kingdom
never adopted the euro, and it left
the EU in 2020 owing to the exit
referendum of June 2016.
Table 21.1 A Brief Glossary of Euronyms
ECB European Central Bank
EEA European Economic Area
EFSF European Financial Stability Facility
EMS European Monetary System
EMU Economic and Monetary Union
ERM Exchange Rate Mechanism
ESCB European System of Central Banks
ESM European Stability Mechanism
EU European Union
OMT Outright Monetary Transactions
SGP Stability and Growth Pact
SRM Single Resolution Mechanism
SSM Single Supervisory Mechanism
Why the EU?
• Countries that established the EU and EMS had several goals
1. To enhance Europe’s power in international affairs: as a
union of countries, the EU could represent more economic
and political power in the world.
2. To make Europe a unified market: a large market with
free trade, free flows of financial assets, and free migration
of people—in addition to fixed exchange rates or a
common currency—was believed to foster economic
growth and economic well-being.
3. To make Europe politically stable and peaceful.
Why the Euro (EMU)?
EU members adopted the euro for four main reasons:
1. Unified market: the belief that greater market integration and
economic growth would occur.
2. Political stability: the belief that a common currency would
make political interests more uniform.
3. The belief that German influence under the EMS would be
moderated under a European System of Central Banks.
4. Elimination of the possibility of devaluations/ revaluations:
with free flows of financial assets, capital flight and speculation
could occur in an EMS with separate currencies, but it would be
more difficult for them to occur in an EMS with a single currency.
The EMS: 1979–1998 (1 of 4)
• From 1979 to 1993, the EMS defined the exchange
rate mechanism to allow most currencies to fluctuate
/ 2.25% around target exchange rates.
• The exchange rate mechanism allowed larger fluctuations
% ( / 6 ) for currencies of Portugal, Spain, Britain (until
1992), and Italy (until 1990).
– These countries wanted greater flexibility with
monetary policy.
– The wider bands were also intended to prevent
speculation caused by differing monetary and fiscal
The EMS: 1979–1998 (2 of 4)
To prevent speculation,
• early in the EMS some exchange controls were also
enforced to limit trading of currencies.
– But from 1987 to 1990 these controls were lifted in
order to make the EU a common market for financial
• 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.
The EMS: 1979–1998 (3 of 4)
• But because of differences in monetary and fiscal policies
across the EMS, market participants began buying
German assets (because of high German interest rates)
and selling other EMS assets.
• As a result, Britain left the EMS in 1992 and allowed the
pound to float against other European currencies.
• As a result, the exchange rate mechanism was redefined
in 1993 to allow for bands of / 15% of the target value in
order devalue many currencies relative to the
deutschemark.
The EMS: 1979–1998 (4 of 4)
• But eventually, each EMS member adopted similarly
restrained fiscal and monetary policies, and the inflation
rates in the EMS eventually converged (and speculation
slowed or stopped).
– In effect, EMS members were following the restrained
monetary policies of Germany, which has traditionally
had low inflation.
– Under the EMS exchange rate mechanism of fixed
bands, Germany was “exporting” its monetary policy.
Figure 21.2 Inflation Convergence for Six
Original EMS Members, 1978–2019
Shown are the differences between domestic inflation and German inflation for six of the
original EMS members: Belgium, Denmark, France, Ireland, Italy, and the Netherlands.
Source: CPI inflation rates from International Monetary Fund, International Financial
Statistics, and BLS.
Brexit (1 of 2)
• On June 23, 2016, British citizens voted to leave the EU.
– Britain had never adopted the euro.
• Stock markets across the world tumbled, and the pound
sterling plummeted.
• Voters want to limit immigration from Eastern Europe,
and the benefits, such as medical care, the UK
government must provide immigrants under EU law.
– Desire to “Take Back Control” from EU regulations in
many dimensions.
• Britain had to negotiate trade deals with every county.
Brexit (2 of 2)
• Under 2019 withdrawal agreement bill, Brexit took place
January 31, 2020 with an 11-month transition period during
which Britain continued to follow EU rules and kept frictionless
trade with other EU countries.
– Added time to negotiate permanent trade agreements.
– A last minute deal achieved mostly tariff and quota-free
trade between Britain and the EU.
– To keep boundary between Northern Ireland (part of
United Kingdom) and the Republic of Ireland free of border
controls led to Northern Ireland still partially in the EU
single market and administrative checks on imports.
U.S. Dollars per Pound, 05/2016-08/2018
Source: Global financial data.
Policies of the EU and EMS (1 of 4)
• The Single European Act of 1986 recommended that many
barriers to trade, financial asset flows, and immigration be
removed by December 1992.
– It also allowed EU policy to be approved with less than
unanimous consent among members.
• The Maastricht Treaty, proposed in 1991, required the three
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
Policies of the EU and EMS (2 of 4)
• The Maastricht Treaty requires that members that want to
enter the economic and monetary union
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%.
Policies of the EU and EMS (3 of 4)
• The Maastricht Treaty requires that members that want to
remain in the economic and monetary union
1. 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%.
– Financial penalties are imposed on countries with
“excessive” deficits or debt.
• The Stability and Growth Pact, negotiated in 1997, also
allows for financial penalties on countries with “excessive”
deficits or debt.
Policies of the EU and EMS (4 of 4)
• The euro was adopted in 1999, and the previous exchange
rate mechanism became obsolete.
• But a new exchange rate mechanism—ERM 2—was
established between the economic and monetary union and
outside countries.
– It allowed countries (either within or outside the EU) that
wanted to enter the economic and monetary union in the
future to maintain stable exchange rates before doing so.
– It allowed EU members outside of the economic and
monetary union to maintain fixed exchange rates if
Theory of Optimum Currency Areas (1 of 12)
• The theory of optimum currency areas argues that the
optimal area for a system of fixed exchange rates, or a
common currency, is one that is highly economically
integrated.
– economic integration means free flows of
▪ goods and services (trade)
▪ financial capital (assets) and physical capital
▪ workers/labor (immigration and emigration)
• The theory was developed by in 1961.
Theory of Optimum Currency Areas (2 of 12)
• Fixed exchange rates have costs and benefits for
countries deciding whether to adhere to them.
• Benefits of fixed exchange rates are that
they avoid the uncertainty and international transaction
costs that floating exchange
rates involve.
• The gain that would occur if a country joined a fixed
exchange rate system is called the monetary efficiency
Theory of Optimum Currency Areas (3 of 12)
• The monetary efficiency gain of joining a fixed exchange rate system
depends on the amount of economic integration.
• Joining fixed exchange rate system would be beneficial for a country
1. trade is extensive between it and member countries, because
transaction costs would be greatly reduced.
2. financial assets flow freely between it and member countries,
because the uncertainty about rates of return would be greatly
3. people migrate freely between it and member countries, because
the uncertainty about the purchasing power of wages would be
greatly reduced.
Theory of Optimum Currency Areas (4 of 12)
• In general, as the degree of economic integration
increases, the monetary efficiency gain increases.
• Draw a graph of the monetary efficiency gain as a
function of the degree of economic integration.
Figure 21.3 The GG Schedule
The upward-sloping GG schedule shows that a country’s monetary
efficiency gain from joining a fixed exchange rate area rises as the
country’s economic integration with the area rises.
Theory of Optimum Currency Areas (5 of 12)
When considering the monetary efficiency gain,
• we have assumed that the members of the fixed exchange
rate system would maintain stable prices.
– But when variable inflation exists among member
countries, then joining the system would not reduce
uncertainty (as much).
• 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).
Theory of Optimum Currency Areas (6 of 12)
• Economic integration also allows prices to converge
between members of a fixed exchange rate system and a
potential member.
– The law of one price is expected to hold better when
markets are integrated.
Theory of Optimum Currency Areas (7 of 12)
• Costs of fixed exchange rates are that they require the
loss of monetary policy for stabilizing output and
employment, and the loss of automatic adjustment of
exchange rates to changes in aggregate demand.
• Define this loss that would occur if a country joined a
fixed exchange rate system as the economic stability
Theory of Optimum Currency Areas (8 of 12)
• The economic stability loss of joining a fixed exchange rate
system also depends on the amount of economic integration.
• After joining a fixed exchange rate system, if the new member
faces a fall in aggregate demand:
1. Relative prices will tend to fall, which will lead other
members to increase aggregate demand greatly if
economic integration is extensive, so that the economic
loss is not as great.
2. Financial assets or labor will migrate to areas with higher
returns or wages if economic integration is extensive, so
that the economic loss is not as great.
Theory of Optimum Currency Areas (9 of 12)
3. The loss of the automatic adjustment of flexible
exchange rates is not as great if goods and services
markets are integrated. Why?
• 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.
Theory of Optimum Currency Areas (10 of 12)
• In general, as the degree of economic integration
increases, the economic stability loss decreases.
• Draw a graph of the economic stability loss as a function
of the degree of economic integration.
Figure 21.4 The LL Schedule
The downward-sloping LL schedule shows that a country’s economic
stability loss from joining a fixed exchange rate area falls as the
country’s economic integration with the area rises.
Theory of Optimum Currency Areas (11 of 12)
• At some critical point measuring the degree of
integration, the monetary efficiency gain will exceed the
economic stability loss for a member considering whether
to join a fixed exchange rate system.
Figure 21.5 Deciding When to Peg the
Exchange Rate
The intersection of GG and LL at point 1 determines a critical level of economic
integration, ,1 between a fixed exchange rate area and a country considering
whether to join. At any level of integration above ,1 the decision to join yields
positive net economic benefits to the joining country.
Theory of Optimum Currency Areas (12 of 12)
• There could be an event that causes the frequency or
magnitude of changes in aggregate demand to increase
for a country.
• If so, the economic stability loss would be greater for
every measure of economic integration between a new
member and members of a fixed exchange rate system.
• How would this affect the critical point where the
monetary efficiency gain equals economic stability loss?
Figure 21.6 An Increase in Output Market
Variability
A rise in the size and frequency of country-specific disturbances to the joining country’s
product markets shifts the LL schedule upward from to1 2LL LL because for a given level of
economic integration with the fixed exchange rate area, the country’s economic stability
loss from pegging its exchange rate rises. The shift in LL raises the critical level of
economic integration at which the exchange rate area is joined to 2.
Is the EU an Optimum Currency
Area? (1 of 4)
• If the EU/EMS/economic and monetary union can be
expected to benefit members, we expect that its
members have a high degree of economic integration:
– large trade volumes as a fraction of GDP
– a large amount of foreign financial investment
and foreign direct investment relative to total
investment
– a large amount of migration across borders as a
fraction of total labor force
Is the EU an Optimum Currency
Area? (2 of 4)
• Deviations from the law of one price also occur in many
EU markets.
– If EU markets were greatly integrated, then the
(currency-adjusted) prices of goods and services
should be nearly the same across markets.
– The price of the same BMW car varies 29.5%
between British and Dutch markets.
Is the EU an Optimum Currency
Area? (3 of 4)
• Regional migration is not extensive in the EU.
• Europe has many languages and cultures, which hinder
migration and labor mobility.
• Unions and regulations also impede labor movements
between industries and countries.
• Differences of U.S. unemployment rates across regions
are smaller and less persistent than differences of
national unemployment rates in the EU, indicating a lack
of EU labor mobility.
Table 21.2 People Changing Region of Residence
in the 1990s (Percent of Total Population)
Britain Germany Italy United States
1.7 1.1 0.5 3.1
Sources: , “Inter-regional Mobility in Europe: A Note on the Cross-Country
Evidence,” Applied Economics Letters 11 (August 2004), pp. 619–624; and
“Geographical Mobility, 2003–2004,” U.S. Department of Commerce, March 2004. Table
data are for Britain in 1996, Germany in 1990, Italy in 1999, and the United States in
Figure 21.7 Unemployment Rates in
Selected EU Countries
Widely divergent unemployment rates moved closer together after the euro’s
launch in 1999 but since the late 2000s have moved sharply apart again.
Source: International Monetary Fund, World Economic Outlook database,
April 2020. Numbers for 2020 are IMF forecasts.
Table 21.3 Assets of Some Individual Banks
as a Ratio to National Output, End-2011
Bank Home country Bank assets
Erste Group Bank Austria 0.68
Dexia Belgium 1.10
BNP Paribus France 0.97
Deutsche Bank Germany 0.82
Bank of Ireland Ireland 0.95
UniCredit Italy 0.59
ING Group Netherlands 2.12
Banco Commercial
Spain 1.19
Source: GDP data from International Monetary Fund, World Economic Outlook
database. Data on bank assets from Viral V. Acharya and , “The ‘Greatest’
Carry Trade Ever? Understanding Eurozone Bank Risks,” Discussion Paper 9432, Centre
for Economic Policy Research, April 2013.
Is the EU an Optimum Currency
Area? (4 of 4)
• There is evidence that financial assets were able to move
more freely within the EU after 1992 and 1999.
• But capital mobility without labor mobility can make the
economic stability loss greater.
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