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UK Membership of the European Monetary Union.

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Introduction

UK Membership of the European Monetary Union 1. Introduction In January of 1999, eleven from fifteen members of the European Union (EU) irrevocably locked their currencies together to become the European Economic and Monetary Union (EMU). Their new common currency, the euro, is now the currency for most of Western Europe. Now one of the biggest questions on the minds of the population is: Should the UK join with the rest of Western Europe in monetary union? 2. Arguments For UK membership: o Lower transactions costs and transparency Joining the Euro would reduce exchange rate uncertainty for businesses and lower transactions costs for companies and tourists. Nearly 60% of UK trade is conducted with other members of the European Union - a figure that is likely to grow in future years. Price differences, especially on big-ticket consumables such as cars, TVs, and washing machines, will become less sustainable and there will be greater price transparency. o Increased trade and investment The Euro is vital to the success of the Single European Market. This should lead to an increase in intra-European trade flows and higher inward investment within the EU region. Britain stands to gain from this, particularly if it can maintain low inflation and raise productivity in European markets. Britain's flexible labour and product markets would be highly effective inside a single currency area and would help to attract even more inward investment from outside the European Union. o Lower inflation and long term interest rates The UK might gain from a period of sustained low-inflation delivered by an independent European Central Bank. If inflation falls, this will lead to lower long-term interest rates and stimulate faster growth and improved competitiveness. The union will be less susceptible to speculative shocks and provides more certainty. The UK has been a major recipient and beneficiary of foreign direct investment in recent years and this might be threatened if the UK remained outside the system in the long run. ...read more.

Middle

Is this now true with the currency? Regionalism * If monetary union is inappropriate for Europe, then this argument could also be applied to parts of the UK, East Anglia and Northern Ireland for example. Britain's economy as a whole is more closely aligned with the European average than Northern Ireland is with Britain; regional variations within countries can be just as great as those between countries. * European economies are slowly becoming ever more naturally integrated with each other, mainly through the activities of international corporations. Trade Patterns * Modern trade is more about trade among businesses in the same industry. Thus the structure of developing economies, particularly Europe, is becoming more integrated, more similar, and less prone to shocks. Any change in consumer tastes is likely to affect Euro-land equally, as with cars for example. Nature of Debt * In the UK the highest consumer debt is mortgages, which are highly sensitive to interest rates - but there are more savers than borrowers. The move to EMU is likely to provide incentives to people to borrow at fixed interest rates for longer periods. Exchange Rate Flexibility and Devaluation Devaluations only work if they lead to a fall in the cost of production after allowing for subsequent price rises. Most devaluation in the UK has only worked in the short term. What you gain by devaluation is lost on the inflationary swing. Social Costs * The single currency alone will not make Europe prosperous. France and Germany are inflexible; both have high indirect social taxes, which threaten growth, such as the working time directive. * Higher payroll taxes are inevitable to finance the irresponsible social policies of France and Germany. European factionalism may eventually destroy EMU. * Some of the UK's advantages - labour market flexibility and low wage costs - have been eroded by government adoption of the social chapter, working time directive, and the national minimum wage. ...read more.

Conclusion

The monetary authority is obliged to supply the currency at the fixed exchange rate, which results in an increase in the money supply. Given a particular shift in the IS curve, the LM curve will shift to intersect the new IS curve at world interest rates. Under fixed exchange rates the money supply is effectively endogenous. 3. Suppose that the European Central Bank decides to tighten its monetary policy. This implies that the European interest rate has increased. a) How would this affect output and the exchange rate in those countries not joining the monetary union (Denmark, Greece, Sweden and the UK)? Their interest rates will below that in the monetary union. Demand for their currencies will fall, leading to a depreciation of their respective currencies (assuming they do not fix their respective exchange rates against the euro). Net exports increase and this leads to higher levels of output in the non-member countries. b) What could the authorities in the non-member countries do to stabilise output? Given that their exchange rates are floating against the euro, only monetary policy has any effect (again assuming PCM). If they wanted to stabilise output (perhaps it was already at potential output) they would have to also reduce their money supplies. c) How would your answers to a) and b) change if the non-member countries had fixed their currencies to the Euro? As in the ERM... a) Demand for their currencies would fall (and supply increase), as investors move their wealth into Euro bonds. The non-member central banks would then be obliged to buy the relevant domestic currency at the agreed exchange rate. Taking this currency out of the market means that the domestic LM curve has shifted to the left (recall LM curves are endogenous under fixed exchange rates). Output will therefore fall. b)Under fixed exchange rates they might use expansionary fiscal effects which would shift the IS curve to the right. ?? ?? ?? ?? Coursework Essay Introductory Macroeconomics Page 1 ...read more.

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