Optimum Currency Areas

1. Optimum Currency Areas

2. Article 2 The Union shall set itself the following objectives: — to promote economic and social progress and a high level of employment and to achieve balanced and sustainable development, in particular through the creation of an area without internal frontiers, through the strengthening of economic and social cohesion and through the establishment of economic and monetary union, ultimately including a single currency in accordance with the provisions of this Treaty.

3. Article 4 2. Concurrently with the foregoing, and as provided in this Treaty and in accordance with the timetable and the procedures set out there in, these activities shall include the irrevocable fixing of exchange rates leading to the introduction of a single currency, the ecu, and the definition and conduct of a single monetary policy and exchange-rate policy the primary objective of both of which shall be to maintain price stability and, without prejudice to this objective, to support the general economic policies in the community, in accordance with the principle of an open market economy with free competition.

4. Optimum Currency Area • A currency area • Optimum Currency Area 4

5. Main advantages of a common currency area • Reduction of transaction costs • Reduction of exchange rate uncertainty • More transparency at goods and factor markets • Macroeconomic stability especially for countries with high inflation rate

6. Costs of common currency • Loss of instruments of macroeconomic policy • Governments can no longer acquire revenue from “seigniorage” 6

7. Types of Shocks Reason • Internal shocks • External shocks Effects • Symmetric shocks • Asymmetric shocks 7

8. Risk of asymmetric shocks • Different industrial structure • Different trade structure • Behavior of labour market. • Preferences in economic policy 8

9. Mitigating the effects of asymmetric shocks • Six OCA criteria. Economic: • Mobility of labour • Openness • Similarities of industrial and trade structures. • Sound federal fiscal system. 9

10. Benefits and costs of markets openness Costs and benefits of Monetary union, % of GDP benefit costs Foreign trade with partner countries, % of GDP

11. Political Criterion: 5) Homogeneous preferences 6) Commonality of destiny Mitigating the effects of asymmetric shocks

12. Macroeconomics of a monetary Union Macroeconomic equilibrium

13. Macroeconomics of a monetary Union Monetary Policy

14. Macroeconomics of a monetary Union Fiscal policy

15. Three stages to Economic and Monetary Union • July 1990 – abolition of all restrictions on the movement of capital • January 1994 – Establishment of the European Monetary Institute (the ECB predecessor) • January 1999 - irrevocable fixing of conversion rates, ECB responsible for monetary policy; 2002 introduction of euro.

16. Fundamentals for EMU

17. Monetary policy autonomy: • Under free mobility of capital: Expected return home = Expected return abroad i = (i* +e) where i = interest rate at home i*= interest rate in foreign country and e = expected rate of depreciation of the home currency

18. Monetary policy autonomy: • Fixed exchange rate regime with credible parities: e = 0, hence i = i*

19. A Target zone system: S – actual exchange rate - `central parity - fluctuation band

20. Problems • n-1 problem. • credibility problem

21. Target zone system

22. Target zone systems in the European Union • 1979: Establishment of EMS (the European Monetary System) which included the target zone system ERM I (Exchange Rate Mechanism). Most of EU countries participated in the system with fluctuation bands at +/- 2.25 %. The goal was to secure exchange stability and low inflation • The ERM system was in principle a symmetric system • In practice the system developed to an asymmetric system with the German mark as the anchor currency

23. Target zone systems in the European Union • Because of this asymmetry monetary policy was pursued in accordance to German interests • Several realignments of the central parities, especially in the 80’s • Growing tensions among the participants in the ERM about the appropriate monetary policy in the beginning of 1990’s. • The growing tensions triggered two dramatic currency crises in 1992/1993. The ERM I was changed radically as the fluctuation bands was increased to +/- 15%

24. Target zone systems in the European Union • The European Council decides in 1997 to establish a new version of ERM – the so called ERM II from 1.1.1999 when euro was launched. The fluctuation bands should be +/- 15%, unless other was agreed upon and the euro should be the anchor currency • The aim of the ERM II is to make up a framework for cooperation between the ‘ins’ and the ‘outs’ of member states and to specify a road to the euro for the outs

25. Target zone systems in the European Union • Participation in the ERM II is voluntary – Denmark participates with a special fluctuation band at +/- 2.25 %, Sweden and United Kingdom stay outside • Mutual commitment to defend the system – however, escape clause for the ECB if intervention will jeopardize price stability

26. Target zone systems in the European Union • Note, that whether or not a member state participate in the ERM II all member states shall in accordance to the Maastricht Treaty treat its exchange rate policy as ‘a matter of common interest’

27. Conditions for a robust target zone system • Large foreign reserves • Sound public finances • International competitiveness • Large fluctuation bands • Stable political system/government

28. ERM II • From1999 January1 Danmark participates • 2004 m. June: Lithuania,Estonia and Slovenia. • 2005 May: Latvia, Malta and Cyprus. • 2005 November: Slovakia.

29. The Maastricht Criteria Price stability: The rate of inflation must not exceed the rate of inflation of the three best performing EU member countries by more than 1,5% Exchange rate stability: The member state must have demonstrated exchange rate stability under the ERM system for at least two years Interest rate convergence: The long term interest rate may not exceed the average interest rate of the three best inflation performing member states by more than 2% Sound public finances: • Public deficit must not exceed 3% of GDP • Public debt must not exceed 60% of GDP

30. CHAPTER 2MONETARY POLICYArticle 105 2. The basic tasks to be carried out through the ESCB shall be: — to define and implement the monetary policy of the Community, — to conduct foreign-exchange operations…, — to hold and manage the official foreign reserves of the Member States, — to promote the smooth operation of payment systems. 30

31. Article 107 1. The ESCB shall be composed of the ECB and of the national central banks. 2. The ECB shall have legal personality. 3. The ESCB shall be governed by the decision-making bodies of the ECB which shall be the Governing Council and the Executive Board. 4. The Statute of the ESCB is laid down in a Protocol annexed to this Treaty.

32. Structure of Europe System of CB ESCB ECB 27 Nacional CB (16 ir 11)‏ Governing council (22) Executive Board(6)‏ General Council(29)‏ six members of the Executive Board, plus the governors of the national central banks of euro zone Jean-Claude Trichet (President), Lucas D. Papademos (Vice-President), 4 members. President, vice president plus the governors of the national central banks of EU Eurosystem

33. Governing Council • to adopt the guidelines and take the decisions necessary to ensure the performance of the tasks entrusted to the Eurosystem; • to formulate monetary policy for the euro area 33

34. Executive Board • to prepare Governing Council meetings; • to implement monetary policy for the euro, • to manage the day-to-day business of the ECB. 34

35. General Council • the ECB's advisory functions; • the collection of statistical information; • the preparation of the ECB's annual reports; • the laying-down of the conditions of employment of the members of staff of the ECB; and other…

36. Main features of the ECB • independence • conservatism   • accountability

37. Independence Goal Instruments Personal Types of Independence 37

38. Independence • Neither the ECB nor the national central banks (NCBs), nor any member of their decision-making bodies, are allowed to seek or take instructions from European Community institutions or bodies, from any government of an EU Member State or from any other body. • Community institutions and bodies and the governments of the Member States must respect this principle and not seek to influence the members of the decision-making bodies of the ECB (Article 108 of the Treaty).

39. Personal independence • The Statute foresees long terms of office for the members of the Governing Council. Members of the Executive Board cannot be re-appointed. 39

40. Monetary Policy The primary objective of the Eurosystem is to maintain price stability: “a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2%”. • Two pillar system: monetary analyses -the reference value for monetary growth – 4.5 % annually economic analyses- assessing the determinants of price developments 40

41. To be more specific: • The consumer price level is measured through special constructed index: HIPC (Harmonised Index of Consumer Prices) for the euro area • ECB looks at the rate of growth of the so called M3 - money supply. M3 includes not only currency in circulation but also time deposit up three months

42. Monetary growth

43. Economic analyses • Wages; • Exchange rate • Profitability of debt instruments • Fiscal policy • Prices and cost analyses • other

44. Is Europe an OCA?Industry structureLabour mobilityFiscal policy

45. In the end • Monetary union is not only about economics • The OCA criteria do not send a clear signal • The EU is not a perfect OCA • A monetary union may function • The OCA criteria tell us where the costs will arise: • Labour markets and unemployment • Political tensions in presence of deep asymmetric shocks 45

46. The Stability and Growth Pact • Formally, the implementation of the Excessive Deficit Procedure (EDP) mandated by the Maastricht Treaty • The EDP aims at preventing a relapse into fiscal indiscipline following entry in euro area • The EDP makes permanent the 3% deficit and 60% debt ceilings and foresees fines • The Pact codifies and formalizes the EDP

47. How the Pact works • Emphasis on the 3% deficit ceiling • Recognition that the budget balance worsens with recessions: • Exceptional circumstances when GDP falls by 2% or more: automatic suspension of the EDP • When GDP falls by more than 0.75%, country may apply for suspension • Precise procedure that goes from warnings to fining

48. The procedure • When the 3% ceiling is not respected • The Commission submits a report to ECOFIN • ECOFIN decides whether the deficit is excessive • If so, ECOFIN issues recommendations with an associated deadline • The country must then take corrective action • Failure to do so and return the deficit below 3% triggers a recommendation by the Commission • ECOFIN decides whether to impose a fine • The whole procedure takes about two years

49. The fine schedule • The fine starts at 0.2% of GDP and rises by 0.1% for each 1% of excess deficit

50. How is the fine levied • The sum is retained from payments from the EU to the country (CAP, Structural and Cohesion Funds) • The fine is imposed every year when the deficit exceeds 3% • The fine is initially considered as a deposit • If the deficit is corrected within two years, the deposit is returned • If it is not corrected within two years, the deposit is considered as a fine