The Euro.

Stage 3 - irrevocable fixing of exchange rates preceding single currency and monetary policy transferred to European Central bank.

The Euro exchange rates were fixed on 1/1/99 and notes and coin were introduced on 1/1/02. It was originally floated at E1 = $1.15 but steadily decreased by more than 30% to E1 = $0.87 but increased to E1 = $1.08 in 2002 and in Feb 04 is standing at E1 = $1.28!

Convergence criteria

* Inflation not to exceed average of inflation in the 3 lowest inflation countries by 1.5%.

* Interest on long-term government bonds must not exceed 2% of average interest rates of countries with the 3 lowest inflation rates.

* Govt deficit to be no more than 3% of GDP

* Govt debt to GDP ratio not to exceed 60%

* FX rates must have been fixed within the narrow ERM band without alignment for more than 2 years.

Cost and Benefits of Monetary Union

* EU has estimated economic benefits to be approx. 10% of EU GNP

* Eliminate transaction costs of FX; estimated at 0.5% of EU GNP

* Elimination of FX risk within EU

* Benefits of greater monetary stability

Resource allocation should improve as prices more accurately reflect where resources should flow within the EU

Stability will encourage trade and investment

However, economic forecasts should always be treated with some caution!

Asymmetric shocks

The effects sof loss of FX rate and monetary policy e.g. Assume a fall in the price of oil in Scotland. If not in monetary union, this would lead to a deficit on the current account. Two ways in which equilibrium could be restored:

General deflation - reductions in wages and prices restoring competitiveness in other areas.

Allow exchange rate to depreciate and make experts cheaper with a reduction in real wages.

If part of monetary union, the economy would go into recession and becomes a depressed region of the EU.

Symmetric shocks

* Business cycles arise out of 3 interacting factors

* Shocks (asymmetric or symmetric)

* Propagation mechanisms (consumption function, investment function etc)

* Policy responses

Symmetric shocks may be followed by different propagation mechanisms leading to different cyclical patterns leading to different policy responses e.g. examination of business cycles as a whole across EU between 1960 and 1990 show little correspondence in relation to timing and magnitude.

Mitigation of the effect of shocks depends upon capital and labour mobility (Friedman). If labour is mobile, then the unemployed may move out of the depressed area to growth area and reduce inflationary pressure in the depressed area. This has been shown to occur in the US. But the EU is not the US! Is it surprising there is no policy debate when migration of labour is a necessary pre-requisite of absorbing shocks? In addition the regions remain depressed. What mechanisms allow for reflating the depressed regions?

Will the Central Bank be independent? It is designed to be independent of political institutions but many fear that to gain credibility, the ECB is conducting tight monetary policy in spite of slow growth in the EU. How can the CB pursue a tight monetary policy in the face of rising unemployment?

It is not possible for a system of exchange rate management to have fixed rates and no controls on capital movements with members pursuing different policies. There is a need for stronger institutional structures with policies to promote growth and regional convergence.