Topic 6: European Monetary Integration and the Euro

Question 1

a) The nominal exchange rate =

Answer 1

the price of one currency in terms of another

Question 2

a) Nominal exchange rates may be

Answer 2

• Spot: for example P£ in terms of $ today

- Forward: for example P£ in $ for collection or delivery in 3 months time

Question 3

a) The effective exchange rate

Answer 3

defines P£ by reference to a weighted basket of other currencies

Question 4

a) The real exchange rate between two currencies

Answer 4

adjusts for differences in purchasing power across countries

Question 5

a) FOREX markets are: (6 points)

Answer 5

24 hour, integrated markets
Populated by a large number of buyers and sellers
include agents in retail and wholesale business
Banks and other financial institutions
Arbitrageurs and speculators
Governments and central banks

Question 6

a) Fixed exchange rates can:

Answer 6

Reduce uncertainty, reduce transactions costs and promote trade and investment
Ensure monetary discipline in a high inflation economy
Promote policy coordination

Question 7

a) disadvantages of fixed exchange rates

Answer 7

Given the existence of forward markets, uncertainty may be overstated
Result in loss of independent monetary and exchange rate policy

Question 8

b) “snake in the tunnel”

Answer 8

managing fluctuations of currencies inside narrow limits (2.25%) agianst $
1972-82

Question 9

b) European Monetary System

Answer 9

stable but adjustable exchange rates defined in relation to the European Currency Unit (basket based on weighted average of EMS currencies)
1982-92

Question 10

b) some histroy of the eurozone (6 points)

Answer 10

1991: Maastricht Treaty and plan for Economic and Monetary Union (Delors Plan)
1993: Copenhagen Criteria for admission
1997: Stability and Growth Pact, to reinforce Maastricht budgetary rules
1998: European Central Bank created
1999: Euro introduced as a unit of account
1999-2002: Exchange rates fixed and Euro launched, national currencies withdrawn

Question 11

b) Optimum Cureency Area Criteira

Answer 11

1) Increased labour mobility (simplified visas, language barriers, transfer of pensions)
2) Currency risk sharing system (distribution of money to areas in economic difficulty)
3) Capital mobility (to facilitate overall trade and boost economies)
4) Similar business cycles

Question 12

c) Eurozone successes (4)

Answer 12

Monetary discipline exerted by the ECB
Low interest rates and stable inflation in Europe
Promotion of trade and cross-border investment
Emergence of the Euro as a reserve currency

Question 13

c) threats to Eurozone (5)

Answer 13

• Flexible membership criteria
  (Superficially hard targets for entry became soft targets)
• Weak enforcement of ‘Stability and Growth Pact’
  (beginning with France and Germany and spreading)
• Increasing divergence in competitiveness
  (Leading to internal payments imbalances)
• No ‘automatic stabilisers’
  (The Eurozone is not a federal state)
• Political drivers
  (On the part of those driving ‘the European project’)

Question 14

c) more details of failure of stability and growth pact

Answer 14

Fr and Ger failed to keep deficit below 3% of GDP, threatened with big fines by EC but not done,

Smaller countries punished more harshly

The rift could threatens the EU, where the balance of power between big and small states is contentious

Question 15

c) more details on admission criteria (5)

Answer 15

1) Exchange rate: two consecutive years in ERM with no devaluation
2) Inflation rate: less than 1.5 percentage points above the average of the lowest three Members
3) Interest rate: less than 2 percentage points above the average of the three lowest Members
4) Government deficit: less than 3% of GDP
5) Government debt: less than 60% 0f GDP
In 1996, three countries met all these conditions, yet twelve were admitted by 2000

Question 16

c) divergence in competitiveness measured by

Answer 16

unit labour costs in manufacturing: high in eg Greece

Question 17

c) more details of no automatic stabilisers

Answer 17

In federal state:

• central support for the financial system
• fiscal transfers between regions
• labour mobility across regions

Question 18

d) impact of the eurozone crisis (7)

Answer 18

Rapidly rising debt
Effective exclusion from bond markets for some countries (Greece, Spain, Ireland)
Prolongation of the credit crunch
Falling cross border financial and trade flows
Falling GDP
Exploding unemployment
Rising political friction

Question 19

e) background to Greece

Answer 19

• Significant under-reporting of public debt in Greece was revealed in 2010
• A latent insolvency problem was exacerbated by the global financial crisis
• Sold investors on the idea that eurozone countries could not default
• EU and IMF made it worse by lending to them to avoid austerity

Question 20

Greece first bailout

Answer 20

• First bailout triggered by the need to repay some sovereign debt by May 2010 coupled with successive downgrading of Greek debt, ultimately to ‘junk status’ in April 2010

Eurozone countries and the IMF lent Greece 110 bn Euro
5.2% average interest payable
In exchange, Greece commited to:
Reducing budget deficit from 13.6% of GDP, to below 3% by 2014
Deficit reductions to be delivered by austerity measures including, increased VAT, excise taxes increased, public sector pay frozen, pensions cut, other public sector benefits reduced