KOM: Chapter 21

What were the 2 main motives for adopting the euro?

1. US became self-interested, so Europeans wanted to unite to better defend their own interests

2. To truly make the EU a unified market. Even though it was established in 1957, it had significant barriers, and significant exchange rate swings was effectively one of them

Why did the UK leave the EU?

They felt there was too much net migration taking their jobs and local services (not backed by evidence) and that EU regulations were too burdensome.

What was the end result of the UK and the EU’s brexit negotations?

1. Northern Ireland and Ireland would still have no barriers, but a checks would occur to goods coming in from Britain

2. The UK could have tariff and quota-free trade with the EU for important manufacturing components but not financial services (major British export) and this could change if regulations differed too much in the future

European Monetary System (EMS)

A formal network of mutually pegged exchange rates begun in March 1979, with intervention arrangements to keep the exchange rates of participating currencies within specified fluctuation margins

What were two safety valves that kept countries in EMS?

1. Having bands that currencies could fluctuate around

2. Having strong economies lend their currency to weaker economies to keep rates fixed

3. (Not a safety valve, but some also had capital controls to stop speculative attacks)

Credibility theory of the EMS

View that the political costs of violating an international exchange rate agreement may be useful in restraining governments from depreciating their currencies to gain the short-term advantage of an economic boom at the long-term cost of higher inflation

Economic and monetary union (EMU)

Goal of a European Union in which national currencies would be replaced by a single EU currency managed by a sole central bank operating on behalf on all EU members

Maastricht Treaty

Agreement to establish a single European currency and a European Central Bank

What are some reasons EU countries went along with the goal of a single shared currency instead of stay with the EMS?

1. Greater integration helps meld Europe into a single market, which was the goal.

2. To stop the asymmetry of the EMS system, where policy would focus on Germany’s condition

3. Free movement of capital meant that there was little benefit of fixed exchange rates but a lot of costs (speculative attacks). It’s best to have one currency

4. Symbolic goal to stop wars in Europe

What are some criteria to be admitted to the EMU?

1. Inflation no more than 1.5% of the average of the 3 lowest EU states

2. Maintained a stable exchange rate within ERM, without devaluating by its own accord

3. Public sector deficit no more than 3% of its GDP

4. Public debt is below or approaching reference level of 60% of its GDP

(It is implied that this is not the full list of criteria)

Stability and Growth Pact (SGP)

Agreement on medium-term budgetary objective of positions close to balance or in surplus, and imposing financial penalties on countries that fail to correct situations of excessive deficits and debt promptly enough

Optimum currency areas

Theory that fixed exchange rates are most appropriate for areas closely integrated through international trade and factor movements

Monetary efficiency gain

Savings when joining a fixed exchange rate system due to avoiding the uncertainty, confusion, and calculation and transaction costs that arise when exchange rates float

Typically a went-integrated country becomes more efficient by pegging to the currency area. Why might this not be the case sometimes?

1. Currency area has greater variability than the pegging currency

2. Economic actors don’t believe the country’s commitment to peg

Economic stability loss

A country joining an exchange rate area gives up its ability to use the exchange rate and monetary policy to stabilize output and employment

T/F: A high degree of economic integration INCREASES the loss of economic stability

FALSE: a high degree of economic integration between a country and the fixed exchange rate area that it joins reduces the resulting economic stability loss due to output market disturbances

What do the GG and LL schedules/curves represent?

GG is the monetary efficiency gain

LL is the economic stability loss

Fiscal federalism

Ability to transfer economic resources from members with healthy economies to those suffering economic setbacks

How do a similar economic structure, fiscal federalism, and unity in banking regulations affect the LL curve respectively?

All three shift the LL curve downward as it increases economic stability

T/F: Even after the introduction of the Euro, unemployment in EU countries varies a lot

True! Even within countries migration seems a lot less common than in the US

Do the authors consider the EU an optimum currency area?

No. It lacks enough intra-European trade, its labor force isn’t very mobile between countries, countries are differently affected by how other countries grow, there isn’t much fiscal federalism, and banking regulation policy still remains at the national level

Default

When a debtor does not make the debt payments it has promised to creditors

The event is called a sovereign default when the debtor is a country’s government

Doom loop

Feedback from bank distress to government borrowing problems and back again

The prospect that some governments might default on their debts hurt banks, and conversely, bank weakness forced governments into expensive bailouts, in a self-reinforcing doom loop

T/F: Capital controls and frequent realignments were essential ingredients in maintaining the system of fixed intra-EU exchange rates until the mid-1980s

True! Eventually capital controls were removed to make for EU market unification