Saturday, June 02, 2007

FE102|Question 7

Explain and discuss the principles of monetary unions in the light of European experience.

The first step in creating a monetary union is the setup of a currency bloc which is defined as when the currencies of all the countries are united by fixed exchange rates. This is hard to do at first so ‘Snakes’ are usually set up that maintain the exchange rates within bands usually defined as a percent change. In addition member countries attempt to follow compatible macroeconomic policies through policy coordination. This was used by most Western European countries during the 1970’s.
Eventually a single currency can replace the individual ones, and this arrangement becomes a monetary union. This system though must have coordinated monetary and fiscal policies encompassing all members. And in the system one state usually assumes the leadership role and as the key currency within the system (trading currency). For the EU experience it was the German State (especially in monetary policy) that members attempted to follow and the Deutschemark was the key currency during the process.

The European Monetary System (EMS) was setup during the 1980’s to arrange for co-operation between members through Exchange Rate Mechanism. ERM attempted to stabilize the cross exchange rates of a wider group of countries and again tied to the Deutschemark.

But some setbacks came when Britain abandoned fixed exchange rages with its partners in 1992.

Hierarchy of the three types of coordination: 1. exchange of information 2. acceptance of mutually consistent policies and 3. joint action. This is versus coordination with no implied significant modification of national policies and thus little more that ‘consultation’.

In 1971, the Snake (other EEC (European Economic Community) countries) in the Tunnel (USA exchange rate) and Belgium/Netherlands being the worm inside the snake.
In 1979, the European Monetary System was established to provide a ‘zone of monetary stability’. The ERM consisted of two parts: 1. bilateral exchange-rate bands (parities) 2. individual currency band against the ECU. The grid in #1 required mutual agreement to make changes and thus Finance Ministers of the currencies participating in the ERM decided these issues.

The ECU was a weighted basket of the 12 member currencies, and from this was an ‘indicator of divergence’. The idea was that it would single out the currency that was diverging from the average agreed parities before bilateral action was required, which in essence was an alarm bell to tell which country needed to take action.
The EMS also established the European Monetary Cooperation Fund (EMCF) where members deposited 20% of their gold dollar reserves in exchange for ECUs that were to be used for exchange market interventions instead of the US dollar. And like any other bank members could draw upon the funds to defend their exchange-rate parities and manage transitory BoP problems.

Results of EMS: Exchange Rate Stability, Anti-Inflation Zone.

Two main components of a Monetary Union; an exchange-rate union and complete capital market integration. More specifically the former means that the countries agree to no margin of fluctuation and thus by all intents and purposes creates a single currency. Complete market integration means that all obstacles to free movement of financial capital are removed and that financial capital is treated equally in all member states.

Implicit requirements: members harmonize their monetary policies, single union central bank, and central bank needs to be invested with a pool of reserves of third-country currencies (US dollars, Japanese Yen...).


A History of the Road to European Monetary Union:

The Rome Treaty of 1957 created the European Economic Community (No Monetary Union) and a priority was the creation of a customs union. The CU involved the adoption of a common tariff policy for third party countries and removal of trade barriers between members.

Hague Summit in 1969 the 6 agreed in principle to establish complete economic and monetary union commencing 1971 and expected completed by 1980. This set up the Werner Report (1972) which the main result was the snake in the tunnel which failed by 1978. This was because of the wide differences in how the economy was handled in each country as a result of the oil crisis and external supply shocks to the system of embargoes. Single European Act (1986) was aimed to create a single market by 1992. Delors report (1989) broadly outlined a proposal for achieving EMU which was initiated by the EEC in 1988 and was to commence in three stages:
1. Greater cooperation and coordination in fiscal and monetary policies as well as removal of financial integration which was the creation of a ‘Single Market project’. (90-93)
2. Phase II was the readying of the eventual permanent fixing of exchange rates and the amendment of the Treaty of Rome which resulted in the signing of the Maastricht Treaty. Established the European Monetary Institute which was to assist progress on economic convergence (European System of Central Banks) and make preparations for the final phase (Statute of the E Central Bank, European System of Central Banks). (1994)
3. Creation of a single monetary policy set by the ECB. 1999

Some acronyms used:
European Union (EU), European Monetary Union (EMU), Exchange Rate Mechanism (ERM), European Currency Unit (ECU), European Monetary Fund (EMF).

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