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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