European Monetary European Monetary Union: Gains and loss Union: Gains and loss from a monetary from a monetary unionunionProf. C. San JuanProf. C. San JuanReference: A. M. El-Agraa. The European Union. Reference: A. M. El-Agraa. The European Union. Economics and Policies. Financial Times-Economics and Policies. Financial Times-Prentice Hall. 2004 (7Prentice Hall. 2004 (7Th.Th. Edition) pp. 144-155 Edition) pp. 144-155

Gains from a monetary Gains from a monetary unionunion 1. Reduce the EU dependence on the dollar1. Reduce the EU dependence on the dollar 2. The Euro is a major world currency able to 2. The Euro is a major world currency able to

compete with the Japanese Yen and the US compete with the Japanese Yen and the US dollardollar

3. Reduction in the cost of financial management3. Reduction in the cost of financial management 4. Permanently fixed exchange rates among 4. Permanently fixed exchange rates among

members of a monetary union for free trade and members of a monetary union for free trade and factor movementsfactor movements

5. When a monetary union establishes a central 5. When a monetary union establishes a central fiscal authority with its own budget, then the fiscal authority with its own budget, then the larger the size of this budget, the higher the larger the size of this budget, the higher the degree of fiscal harmonizationdegree of fiscal harmonization

Loss due to a monetary Loss due to a monetary unionunion Fleming-Corden analysisFleming-Corden analysis

Assume there are 3 countries involved: H (host country), Assume there are 3 countries involved: H (host country), P (potential partner country), W (rest of the world)P (potential partner country), W (rest of the world)

In order to maintain internal and external equilibrium, H In order to maintain internal and external equilibrium, H needs to devalue its currency relative to W, P needs to needs to devalue its currency relative to W, P needs to revalue its currency relative to Wrevalue its currency relative to W

However, if they are in an exchange-rate union, H and P However, if they are in an exchange-rate union, H and P must devalue or revalue their currency togethermust devalue or revalue their currency together

If countries deprive themselves of rates of exchange as If countries deprive themselves of rates of exchange as policy instruments, they impose on themselves losses policy instruments, they impose on themselves losses that are essentially losses emanating from enforced that are essentially losses emanating from enforced departure from internal balancedeparture from internal balance

Graph of the Fleming-Corden Graph of the Fleming-Corden analysis of monetary integrationanalysis of monetary integration

Introducing vertical Introducing vertical Phillips curve Phillips curve

The previous model is base in the traditional The previous model is base in the traditional Phillips curve that assume a trade-off between Phillips curve that assume a trade-off between unemployment and inflation.unemployment and inflation.

The next step is modify the model introducing The next step is modify the model introducing the vertical Phillips curve that asume a the vertical Phillips curve that asume a natural natural unemployment rateunemployment rate characteristic of each characteristic of each country.country.

Under these NAIRU (non accelerating inflation Under these NAIRU (non accelerating inflation rate of unemployment) model the long run rate of unemployment) model the long run unemployment rate is constant, so the Phillips unemployment rate is constant, so the Phillips curve is vertical (see next graph)curve is vertical (see next graph)

Graph of vertical Phillips Graph of vertical Phillips curve curve

Implications of the change Implications of the change from normal Phillips curve from normal Phillips curve to verticalto vertical

1. Monetary integration will have 1. Monetary integration will have no long-term no long-term effecteffect on either partner’s rate of unemployment on either partner’s rate of unemployment since this will be fixed at the appropriate since this will be fixed at the appropriate natural rate for each countrynatural rate for each country

2. If monetary integration is adopted to bring 2. If monetary integration is adopted to bring about balanced growth as well as equal natural about balanced growth as well as equal natural rates of unemployment, this can be achieved rates of unemployment, this can be achieved only if other policy instruments are introduced only if other policy instruments are introduced to bring about to bring about uniformity in the two labor uniformity in the two labor markets markets

Monetary integration with expectations-Monetary integration with expectations-augmented Phillips curvesaugmented Phillips curves

Reasons for the invalidity of Reasons for the invalidity of the Fleming-Corden the Fleming-Corden conclusionconclusion

1. The monetary union is not forgoing the availability of 1. The monetary union is not forgoing the availability of exchange rate variations relative to the outside worldexchange rate variations relative to the outside world

2. The situation does not lead to surplus regions 2. The situation does not lead to surplus regions financing deficit regions indefinitely because no single financing deficit regions indefinitely because no single region is likely to be in deficit or surplus permanently region is likely to be in deficit or surplus permanently

3. Assumptions made by Fleming and Corden are 3. Assumptions made by Fleming and Corden are extremely controversialextremely controversial

4. In practice there would never be a separation between 4. In practice there would never be a separation between the exchange-rate union and market integration. the exchange-rate union and market integration. Devaluation is nothing but a temporary adjustment Devaluation is nothing but a temporary adjustment device as the discussion of the monetary approach to the device as the discussion of the monetary approach to the balance of payments has shown balance of payments has shown

The The Five Test Framework Five Test Framework for the UKfor the UK to integrate in to integrate in the Eurozonethe Eurozone

1. Are business cycles and economic structures 1. Are business cycles and economic structures compatible so that we and others could live compatible so that we and others could live comfortably with euro interest rates on a permanent comfortably with euro interest rates on a permanent basis?basis?

2. If problems emerge is there sufficient flexibility to 2. If problems emerge is there sufficient flexibility to deal with them?deal with them?

3. Would joining EMU create better conditions for firms 3. Would joining EMU create better conditions for firms making long-term decisions to invest in Britain?making long-term decisions to invest in Britain?

4. What impact would entry into EMU have on the 4. What impact would entry into EMU have on the competitive position of the UK`s financial services competitive position of the UK`s financial services industry, particularly the City´s wholesale market?industry, particularly the City´s wholesale market?

5. In summary, will joining EMU promote higher growth, 5. In summary, will joining EMU promote higher growth, stability and a lasting increase in jobs?stability and a lasting increase in jobs?

ReferencesReferences

El-Agraa, Ali M. (1999): The economics of the El-Agraa, Ali M. (1999): The economics of the European Community. Harvester Wheatsheat. European Community. Harvester Wheatsheat. 4th edition.4th edition.

httphttp://://ideas.repec.orgideas.repec.org/p/san//p/san/crieffcrieff/9620./9620.htmlhtml httphttp://://interzone.cominterzone.com//~cheung~cheung//SUM.dirSUM.dir

/econthym1./econthym1.htmlhtml http://www.euro.gov.uk/http://www.euro.gov.uk/