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The European Union-EMS Policies Theory of optimal currency areas Optimum currency areas Bill Gibson UVM 28 April Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency The European Union is a system of international institutions, Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency The European Union is a system of international institutions, Now represents 27 European countries through the: Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency The European Union is a system of international institutions, Now represents 27 European countries through the: European Parliament: elected by citizens of member countries Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency The European Union is a system of international institutions, Now represents 27 European countries through the: European Parliament: elected by citizens of member countries Council of the European Union: appointed by governments of the member countries Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency The European Union is a system of international institutions, Now represents 27 European countries through the: European Parliament: elected by citizens of member countries Council of the European Union: appointed by governments of the member countries Court of Justice: interprets EU law Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency The European Union is a system of international institutions, Now represents 27 European countries through the: European Parliament: elected by citizens of member countries Council of the European Union: appointed by governments of the member countries Court of Justice: interprets EU law Example Does Europe have a common central bank? Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas EU Jan 1 1999 11 member countries of EU adopted common currency The European Union is a system of international institutions, Now represents 27 European countries through the: European Parliament: elected by citizens of member countries Council of the European Union: appointed by governments of the member countries Court of Justice: interprets EU law Example Does Europe have a common central bank? Answer: Yes...European Central Bank, which conducts monetary policy, through a system of member country banks called the European System of Central Banks Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas The European Monetary System Originally a system of fixed exchange rates implemented in 1979-1998 through an exchange rate mechanism (ERM) Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas The European Monetary System Originally a system of fixed exchange rates implemented in 1979-1998 through an exchange rate mechanism (ERM) Morphed into more extensive system of coordinated economic and monetary policies Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas The European Monetary System Originally a system of fixed exchange rates implemented in 1979-1998 through an exchange rate mechanism (ERM) Morphed into more extensive system of coordinated economic and monetary policies Have maintain low budget deficits raise 2.25 % band to 6 % for Portugal, Spain and UK (until 1992) Italy (until 1990) Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas The European Monetary System Originally a system of fixed exchange rates implemented in 1979-1998 through an exchange rate mechanism (ERM) Morphed into more extensive system of coordinated economic and monetary policies Have maintain low budget deficits raise 2.25 % band to 6 % for Portugal, Spain and UK (until 1992) Italy (until 1990) Adopt Euro (Denmark, UK and Switzerland and others did not) Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas The European Monetary System Originally a system of fixed exchange rates implemented in 1979-1998 through an exchange rate mechanism (ERM) Morphed into more extensive system of coordinated economic and monetary policies Have maintain low budget deficits raise 2.25 % band to 6 % for Portugal, Spain and UK (until 1992) Italy (until 1990) Adopt Euro (Denmark, UK and Switzerland and others did not) Open current and capital account Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas The European Monetary System Originally a system of fixed exchange rates implemented in 1979-1998 through an exchange rate mechanism (ERM) Morphed into more extensive system of coordinated economic and monetary policies Have maintain low budget deficits raise 2.25 % band to 6 % for Portugal, Spain and UK (until 1992) Italy (until 1990) Adopt Euro (Denmark, UK and Switzerland and others did not) Open current and capital account Example Does economic theory support the idea of a monetary union? Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas The European Monetary System Originally a system of fixed exchange rates implemented in 1979-1998 through an exchange rate mechanism (ERM) Morphed into more extensive system of coordinated economic and monetary policies Have maintain low budget deficits raise 2.25 % band to 6 % for Portugal, Spain and UK (until 1992) Italy (until 1990) Adopt Euro (Denmark, UK and Switzerland and others did not) Open current and capital account Example Does economic theory support the idea of a monetary union? Answer: Yes: this is unified market with free trade, free flows of financial assets and free migration Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) The belief that German influence under the EMS would be moderated under a European System of Central Banks. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) The belief that German influence under the EMS would be moderated under a European System of Central Banks. Eliminate the possibility of “beggar thy neighbor policies” Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) The belief that German influence under the EMS would be moderated under a European System of Central Banks. Eliminate the possibility of “beggar thy neighbor policies” Market participants buying German assets (because of high German interest rates) and selling other EMS assets Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) The belief that German influence under the EMS would be moderated under a European System of Central Banks. Eliminate the possibility of “beggar thy neighbor policies” Market participants buying German assets (because of high German interest rates) and selling other EMS assets Germany had higher interest rates Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) The belief that German influence under the EMS would be moderated under a European System of Central Banks. Eliminate the possibility of “beggar thy neighbor policies” Market participants buying German assets (because of high German interest rates) and selling other EMS assets Germany had higher interest rates As a result, 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. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) The belief that German influence under the EMS would be moderated under a European System of Central Banks. Eliminate the possibility of “beggar thy neighbor policies” Market participants buying German assets (because of high German interest rates) and selling other EMS assets Germany had higher interest rates As a result, 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. Example Could this last? Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas If Europe to Compete with U.S. Must have unified market Prevent countries from printing money (like US states) The belief that German influence under the EMS would be moderated under a European System of Central Banks. Eliminate the possibility of “beggar thy neighbor policies” Market participants buying German assets (because of high German interest rates) and selling other EMS assets Germany had higher interest rates As a result, 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. Example Could this last? Answer: Eventually, each EMS member adopted similarly Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Attain exchange rate stability defined by the ERM before adopting the euro Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Attain exchange rate stability defined by the ERM before adopting the euro Attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest national inflation rates among EU members. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Attain exchange rate stability defined by the ERM before adopting the euro Attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest national inflation rates among EU members. 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 %. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Attain exchange rate stability defined by the ERM before adopting the euro Attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest national inflation rates among EU members. 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 on countries with excessive deficits or debt Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Attain exchange rate stability defined by the ERM before adopting the euro Attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest national inflation rates among EU members. 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 on countries with excessive deficits or debt Bill Gibson University of Vermont Basic Washington Consensus policies The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Attain exchange rate stability defined by the ERM before adopting the euro Attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest national inflation rates among EU members. 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 on countries with excessive deficits or debt Bill Gibson University of Vermont Basic Washington Consensus policies The European Union-EMS Policies Theory of optimal currency areas Maastricht Treaty Proposed in 1991, It also required standardizing regulations and centralizing foreign and defense policies among EU countries. Some EU/EMS members have not ratified all of the clauses Required the 3 provisions to transform the EMS into a economic and monetary union. Attain exchange rate stability defined by the ERM before adopting the euro Attain price stability: a maximum inflation rate of 1.5% above the average of the three lowest national inflation rates among EU members. 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 on countries with excessive deficits or debt Bill Gibson University of Vermont Basic Washington Consensus policies The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete ERM 2 set up between the economic and monetary union and outside countries Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete ERM 2 set up between the economic and monetary union and outside countries Allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete ERM 2 set up between the economic and monetary union and outside countries Allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union Allowed EU members outside of the economic and monetary union to maintain Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete ERM 2 set up between the economic and monetary union and outside countries Allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union Allowed EU members outside of the economic and monetary union to maintain Became currency area Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete ERM 2 set up between the economic and monetary union and outside countries Allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union Allowed EU members outside of the economic and monetary union to maintain Became currency area Large increase in trade between countries after euro adopted Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete ERM 2 set up between the economic and monetary union and outside countries Allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union Allowed EU members outside of the economic and monetary union to maintain Became currency area Large increase in trade between countries after euro adopted Example Do common currency area promote growth Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Euro adopted in 1999 ERM became obsolete ERM 2 set up between the economic and monetary union and outside countries Allowed countries (either within or outside of the EU) that wanted to enter the economic and monetary union Allowed EU members outside of the economic and monetary union to maintain Became currency area Large increase in trade between countries after euro adopted Example Do common currency area promote growth Answer: Yes...because of increased specialization and trade. Law of one price given shot in the arm! Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Optimal Currency Areas Robert Mundell in 1961 Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Optimal Currency Areas Robert Mundell in 1961 Define gain that would occur if a country joined a fixed exchange rate system as the monetary efficiency gain Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Optimal Currency Areas Robert Mundell in 1961 Define gain that would occur if a country joined a fixed exchange rate system as the monetary efficiency gain Larger if trade is extensive between it and member countries, because transaction costs would be reduced greatly. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Optimal Currency Areas Robert Mundell in 1961 Define gain that would occur if a country joined a fixed exchange rate system as the monetary efficiency gain Larger if trade is extensive between it and member countries, because transaction costs would be reduced greatly. Larger if financial assets flow freely between it and member countries, because the uncertainty about rates of return would be reduced greatly Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Optimal Currency Areas Robert Mundell in 1961 Define gain that would occur if a country joined a fixed exchange rate system as the monetary efficiency gain Larger if trade is extensive between it and member countries, because transaction costs would be reduced greatly. Larger if financial assets flow freely between it and member countries, because the uncertainty about rates of return would be reduced greatly Larger if people migrate freely between it and member countries, because the uncertainty about the purchasing power of wages would be reduced greatly Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment Loss of automatic adjustment of exchange rates to changes in aggregate demand Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment 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 loss Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment 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 loss The economic stability loss of joining a fixed exchange rate system also depends on the amount of economic integration. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment 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 loss The economic stability loss of joining a fixed exchange rate system also depends on the amount of economic integration. Fall in aggregate demand is compensated by fall in prices-increases demand from other areas Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment 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 loss The economic stability loss of joining a fixed exchange rate system also depends on the amount of economic integration. Fall in aggregate demand is compensated by fall in prices-increases demand from other areas Depends on the amount of economic integration. Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment 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 loss The economic stability loss of joining a fixed exchange rate system also depends on the amount of economic integration. Fall in aggregate demand is compensated by fall in prices-increases demand from other areas Depends on the amount of economic integration. Example Does this loss occur for states? Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Costs Loss of monetary policy for stabilizing output and employment 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 loss The economic stability loss of joining a fixed exchange rate system also depends on the amount of economic integration. Fall in aggregate demand is compensated by fall in prices-increases demand from other areas Depends on the amount of economic integration. Example Does this loss occur for states? Answer: No! Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Robert Mundell 1999 Nobel Price Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Bill Gibson University of Vermont The European Union-EMS Policies Theory of optimal currency areas Bill Gibson University of Vermont