As well as our interest rates being too high, so too is the value of our currency. To join, we would have to first devalue sterling to the equivalent of being in the narrow band of the ERM for at least two years. The J curve demonstrates the problems in the short term of a devaluation of a currency. That is, in the short run, demand for exports and imports is price inelastic. It takes time for foreigners to react to the devaluation, so export values often remain unchanged. Import values however would rise. The price of imports would be relatively more expensive, but UK buyers may well be stuck with import contracts, signed before the devaluation, and so the current account may worsen.
- EU consumers and producers
EU consumers would benefit from Britain joining the Euro, as they would be able to buy UK goods and services without having to waste time and money changing the currency. A single currency would make it impossible for goods and services to be priced differently in different countries. At the moment, the different currencies mean consumers are less likely to notice price differentials between countries. With one currency, price differentials would be obvious and there would be downward pressure on prices as a result of this increased price transparency. Firms will therefore find it very difficult to segment the market and charge the desired higher price.
We’ve already mentioned that entering a single currency will further lower barriers to entry, and this will also increase competition within the EU. Domestic firms will be under pressure to cut costs and so produce more efficiently then before, further benefiting the consumer in the form of price cuts. There would be mixed opinions about the Single Currency among firms. In the short run, there would be massive menu costs. But this would be a one-off cost to firms, and so is myopic and superfluous. However, firms can only achieve full Economies of Scale once different currencies are abolished, and firms are happy to expand into Europe without the fear of exchange rate fluctuations. Economies of Scale are an example of dynamic gains of being apart of the common market. The absence of barriers should also result in information being exploited faster, and perhaps benefit firms in the form of more R & D, and so higher productivity. Competition would encourage innovation, reduce costs of production and lower prices for the consumer. There will therefore be gains in productive and allocative efficiency. However, the move to the single currency could be just as damaging to firms as it I rewarding. Some firms might not be able to compete with the increase in the level of competition, and so might be forced to exit the market altogether, resulting in higher unemployment, and more reliance on imported goods, therefore damaging the domestic economy two-fold. Also, the labour market is becoming more and more inflexible due to the implementation of EU policies, such as the Social Charter, and the minimum wage, which both give more rights to the worker, and so increasing the costs to the firm.
- UK macroeconomic management
Before a single currency, if a country was going through recession, one solution to this would have been to devalue its currency. In a single currency, this tool is no longer available.
There are 3 alternatives: Labour should be mobile, moving away from areas of high unemployment. However, this is unlikely in Europe, not least because of language barriers. Wages should be flexible downwards, solving the unemployment problem, however wages aren’t flexible downwards, not least because of minimum wages and Trade Unions. There should also be fiscal transfers from other EU countries, however, there is no mechanism for this in Europe, and it would probably be unacceptable to rich countries like Germany. If there is a likelihood of a country suffering from asymmetric shock, then there is a real problem associated with single currency membership.
At the moment, the UK economy is experiencing record levels of low unemployment. Therefore, I doubt joining a single currency could improve our current situation. In fact, in the short term, according to the J curve, the UK will experience higher levels of unemployment in the short term. For low inflation, again the UK is fairing well in comparison to other European countries, however, joining the Single Currency wouldn’t change that too much as the German style anti-inflationary bias of the ECB is likely to result in low inflation anyway. In terms of Economic Growth, the UK could benefit. Firms are generally in favour of the move towards the Euro, as they will be able to exploit full Economies of Scale, and produce at a lower unit cost, therefore maximising revenues. With firms retaining higher profits, they may give wage increases, and so increase the amount workers have to spend, or firms may decide to spend their revenue on R & D, or increase investment. Either way, there is an increase in aggregate demand in the economy, and so economic growth could well take place. Joining the Euro will make UK goods more competitive as they will have decreased in value, and so demand for exports may well increase, so too will the demand for imports decrease, as they have become relatively less competitive. Therefore the balance on the current account will improve. But with lower interest rates, fewer firms will be encouraged to invest in UK financial businesses, and so the capital account balance will probably worsen.