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Tutorial 5 Euro

Economic & Monetary Union (EMU) - agreement among the participating member states of the European Union to adopt a single hard currency & monetary system. Advantages: 1. Price transparency - Problem of different exchange rates could be eliminated. Accurately compare the price of goods, service & resources across the EU. - Encourage cross-border trade & increase competitive pressures across variety of market. - Consumer welfare improved. 2. Eliminate transaction cost - No need to spend to buy & sell foreign currencies to do business in EU - Long term benefits for households 3. Increase trade flow - Trade flow between UK & other EU nations will increase. Investment will be boosted up & product market will become more competitive as no problem of fluctuation in exchange rates. - Encourage specialization & further exploitation of the UKs comparative advantages in several sector of the economy in the longer term. 4. Prevent war - A political project. Step towards European integration, trade effectively together.

Disadvantages: 1. Deflationary tendencies - In order to reduce deficit or inflation, country has to deflate its economy. 2. System instability - Impossible to maintain exchange rate stable with ERM (exchange rate mechanism) 3. Lack of real economy convergence - Member economies have not converged fully in real or structural sense. - Interest rate is impossible to be optimum for every country. 4. Loss of sovereignty - Undesirable as gov would lose the ability to control policy Euro Definition The official currency of the Eurozone, which consists of 17 of the 27 member states of the European Union. (Eurozone: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, Netherlands, Portugal, Slovakia, Slovenia & Spain) 2nd largest reserve currency & the most traded currency in the world after the US dollar.

Failure Initial political goal of creating a harmonious Europe & greater sense of belonging to a community - has failed. 1 single currency on a very heterogeneous group of countries is hardly achievable.

Two Main Reasons 1. Severe discrepancy in economic competitiveness. Since Eurozone is divided into a relatively vigorous northern tier (e.g. German) with sound finances and a southern one with crushing debts and nonexistent growth prospects. German workers are simply much more efficient and competitive than Southern countries of Portugal, Italy, Greece & Spain. (Sometimes called as PIGS) Germany is an exporting machine and is sending a huge amount of goods and services to the PIGS, n hence running a huge surplus with those countries. Whiles PIGS suffered large trade deficits (import) This 1 way to solve this is to allow their PIDS currencies to be depreciated against Germany in order to make their export more competitive & cheaper Unlike US, Europe has no federal fiscal system to transfer resources from prosperous to troubled regions & European leaders seem unwilling to create one. 2. Monetary policy flexibility Since membership of the Eurozone establishes a single policy, individual member states can no longer act independently print money to ease their risk of default. The gov of the EU control that loses their monetary authority in control the supply of money. For others non-EU countries, the Central bank may use expansionary monetary policy that used to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice a business into expanding. Contractionary monetary policy will be used to slow inflation to avoid the distortions and deterioration of assets values.

Ways to Solve 1. Commercial Banks should increase the capital ratios and the size of the European Financial Stability Facility (EFSF) Provide insurance guarantees that would allow Italy and potentially Spain (Weak countries) to access capital markets at reasonable interest rates. Failed. Banks dont want to dilute the holdings of their current stakeholders 2. Calls for the ECB to buy the bonds of Italy, Spain, & other countries with high debt to keep their interest rates low (advocated by France) Germany opposes this move as its inflationary potential & the risk of losses in those bonds. 3. Call the fiscal union in which those countries with budget surpluses would transfer funds each year to the countries running budget deficits and trade deficits.

Discuss the effect of a single currency on Greece and the benefit of leaving European Monetary Union.

Effect of a single currency on Greece: Greece faces the persistent problem of a rising current account deficit (productivity increase more slowly than Germanys, causing the price of Greek goods to rise relative to the prices of other EU goods. Deterioration of Greek competitiveness in the future. (Continuous borrowing to finance its current account imbalance.

Benefits of leaving: Exchange rate would adjust over time to prevent large & growing trade deficit. The need to finance that trade deficit would cause the value of the Greek currency to decline, making Greek exports more attractive to foreign buyers & encouraging Greek consumers to substitute Greek goods & services for imports