Monetary Union

The three stages

  1. Creation of a Single European Market.
  2. Co-ordination of national government monetary policies and convergence of business cycles.
  3. Creation of monetary union, the Euro and the European Central Bank.

Exchange rates

Exchange rate supply and demand diagram

The Euro follows the floating exchange rate system, the exchange rate is determined by the interaction of supply and demand. To keep the exchange rate within limits EL and EU the ECB can intervene and change interest rates.

Convergence criteria

To allow the Euro to function effectively 5 key criteria needed to be met both before establishing and after creation of the Eurozone.

  1. Government budget deficit no more than 3% of GDP
  2. Government (national) debt no more than 60% of GDP
  3. Low inflation (the average rate of inflation in the three EU members with the lowest inflation ±1.5%)
  4. Low long term interest rates (the average rate of the three economies used for the third condition ±2%)
  5. Exchange rate stability

Fiscal policy has two key elements; firstly automatic spending such as that on unemployment benefit, the level of spending on which the government does not directly control and secondly discretionary fiscal policy used to deliberately stimulate or cool down the economy. The convergence criteria required discipline in discretionary fiscal policy as outlined above, but not in automatic spending. It is worth noting that the first condition - that debt does not exceed 5% of GDP - was broken by both Germany and France ironically a condition strongly favoured by both economies to curb the high levels of borrowing in other members like Italy who it was feared may create inflationary pressures within the union.

European Stability and Growth Pact

The pact focused on the implementation of the first of the convergence criteria, giving the EU Commission the power to fine economies up to 0.5% of their GDP for breaking the rules. The pact aimed to bring about fiscal policy harmonisation by removing the ability of economies to use government spending as a tool for demand management.

The pact was formed in 1996 and though the terms of the agreement have been broken for political and economic reasons the pact is not likely to be disbanded.

UK's criteria

Gordon Brown has set out five criteria which must be met before the UK considers joining the EU, which are as follows.

  1. Convergence (of business cycles, inflation rate and interest rates) between the UK and Eurozone.
  2. Flexibility once in the EZ.
  3. If the UK will benefit from increased investment by adopting the Euro.
  4. The affect on financial services. Currently London is a financial centre for global trade. If the UK joined the Euro the UK would lose it's independent stock exchange and may see financial services move to Frankfurt.
  5. The long term prospects in terms of future ability to maintain growth, a stable economy and job creation.

These notes are from a lesson on 11th May 2005.