Slides from a revision webinar on aspects of European Monetary Union designed for A level economics.

1. Monetary Union
Year 2 Macro Revision

2. What is a Monetary Union?
• Monetary union is a deeper form of integration
1. Free trade agreement
2. Customs union
3. Single market
4. Monetary union
5. Fiscal union / political union
• The single European currency, the euro, was introduced in
1999 and came into common circulation in January 2002
• No country has yet left the Euro Area
• As of May 2017, there are nineteen member nations
• Of the 28 EU countries (the UK leaves in 2019), 9 are not
part of the single currency including Denmark, Hungary,
the Czech Republic and Poland

3. European Monetary Union
Country
Joined
EU
Euro Zone
Member?
Country
Joined
EU
Euro Zone
Member?
Austria 1995 Yes Italy 1957 Yes
Belgium 1957 Yes Latvia 2004 Yes
Bulgaria 2007 No Lithuania 2004 Yes
Croatia 2013 No Luxembourg 1957 Yes
Cyprus 2004 Yes Malta 2004 Yes
Czech Republic 2004 No Netherlands 1957 Yes
Denmark 1973 No (ERMII) Poland 2004 No
Estonia 2004 Yes Portugal 1986 Yes
Finland 1995 Yes Romania 2007 No
France 1957 Yes Slovakia 2004 Yes
Germany 1957 Yes Slovenia 2004 Yes
Greece 1981 Yes Spain 1986 Yes
Hungary 2004 No Sweden 1995 No
Ireland 1973 Yes United Kingdom 1973 No (leaving EU)
ERMII is a fixed exchange rate system for countries considering joining the Euro at some future point Denmark is the sole member of ERMII.

4. Context: Countries that have not made a currency union
Czech Republic Hungary
Poland
Norway
Sweden
USA
Canada
Currency unions tend to work best with a cluster of countries that have real economic
convergence and high labour market flexibility – these nations have chosen not to form one
The Czech Republic, Hungary and Poland all came into the EU in May 2004 but have opted to
remain outside of the Euro Area and maintain instead a floating exchange rate with the Euro.

5. Some dynamic convergence for non-Euro Area nations

6. But not for some southern European EA members

7. Pattern of Exports of Goods sold by Czech Republic

8. Czech Republic’s Main Export Markets

9. Real Effective Exchange Rate for Czech Republic
80
85
90
95
100
105
110
115
1/1/05
7/1/05
1/1/06
7/1/06
1/1/07
7/1/07
1/1/08
7/1/08
1/1/09
7/1/09
1/1/10
7/1/10
1/1/11
7/1/11
1/1/12
7/1/12
1/1/13
7/1/13
1/1/14
7/1/14
1/1/15
7/1/15
1/1/16
7/1/16
1/1/17
Effective Exchange Rate Index for Czech Republic
Depreciation – makes Czech
exports more price
competitive

10. Potential advantages from joining the Euro
Euro is more
stable than
smaller
currencies
Reduced
currency risk
makes it
cheaper for
smaller
countries to
borrow
Currency risk
Euro
enhances the
welfare gains
from being in
the single
market – e.g.
it encourages
more cross
border trade
Trade
Membership
of Euro likely
to stimulate
inward
investment in
industries
such as
tourism,
financial
services, car-
making
Investment
Euro increases
price
transparency
which then
helps
consumers to
find products
at better
prices
Competition
Shared
currency cuts
the costly
conversion of
money, it
might also
improve
labour
mobility
within the
single market
Transactions
Joining the single currency is a hugely significant economic and political choice and not one
that countries will make without considering the likely benefits and the risks involved

11. Joining the Euro – Convergence Criteria
• According to the rule, to join the single currency, a country
must meet the following convergence criteria.
1. Stable prices: Inflation must not be more than 1.5% higher
than the average in the three member countries with best
price stability, i.e. lowest inflation.
2. Stable exchange rate: The national currency must have been
stable relative to other EU currencies for a period of two
years prior to entry into the monetary union
3. Sound government finances:
• Total government debt must not exceed 60 per cent of GDP
• The annual budget deficit must not be greater than 3 per cent of GDP
4. Interest rate convergence: The 5-year government bond
interest rate must not be more than 2 per cent higher than
the average of existing Euro Zone members

12. What is an Optimal Currency Area (OCA)?
• According to Mundell, an OCA works best when
1. Countries are highly integrated with each other i.e. a high
percentage of trade is with fellow currency union nations
2. Where each economy has a flexible labour market to cope with
external shocks. Labour market flexibility might include:
• Flexibility in real wages and salaries at different times in an economic cycle
• Workers with adaptable skills to reduce the risk of structural unemployment
• High geographical mobility within & between nations of a currency union
• Flexible employment contracts including lots of short-term job contracts
3. When the effects of interest rate changes or a movement in the
exchange rate have a broadly similar effect on businesses and
households from country to country.
4. When member nations are willing to make fiscal transfers
between each other, for example to help stabilize aggregate
demand and provide financial support during difficult times

13. Real Economic Convergence
• Some people believe that economies entering the single currency perform
better in the long run if they are closer in a real sense – indicators include:
1. Trend growth of real GDP - linked to productivity growth & investment
2. Patterns of international trade in goods and services are relatively
similar
3. Housing market structure e.g. levels of home ownership, reliance on
mortgage finance, relative size of the rented housing sector
4. Policy response: Countries whose economies respond in a symmetrical
way to a change in monetary policy e.g. when a central bank makes a
change to policy interest rates
5. Vulnerability to external shocks: Countries who respond in a
symmetrical way to external shocks such as changes in oil and gas prices
and prices of other internationally-traded commodities.
• Because the member nations of the Euro are different – this makes it
virtually impossible for the ECB to find a ‘one-size fits all’ interest rate.

14. Key Problems Facing the Euro Area Economy
High structural
unemployment +
hysteresis effects
High levels of
government debt +
high bond yields
for some
Risks from price
deflation
Persistently low
aggregate demand
/ spare capacity
Fragile banking
sector (non-
performing loans)
Weak capital
investment – some
diverting to
emerging Asia
Big trade / current
account
imbalances
Political tensions
and ongoing
refugee crisis
Declines in
subjective
wellbeing + rise in
poverty

15. Macro Developments in the Euro Area
Year 2 Macro

16. The Euro Zone has experienced persistent slow growth
-1.5%
-1.0%
-0.5%
0.0%
0.5%
1.0%
1.5%
2.0%
2.5%
2010 2011 2012 2013 2014 2015 2016* 2017* 2018* 2019* 2020*
GDPgrowthcomparedtopreviousyear
EU Euro area
Source: IMF World Economic Outlook

17. Economic Cycle in the Euro Area
1500000
1700000
1900000
2100000
2300000
2500000
2700000
1/1/95
12/1/95
11/1/96
10/1/97
9/1/98
8/1/99
7/1/00
6/1/01
5/1/02
4/1/03
3/1/04
2/1/05
1/1/06
12/1/06
11/1/07
10/1/08
9/1/09
8/1/10
7/1/11
6/1/12
5/1/13
4/1/14
3/1/15
2/1/16
1/1/17
Real GDP for Euro Area

18. What an economic depression looks like
70
75
80
85
90
95
100
105
110
115
2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Real GDP
Index Q4 2007 = 100
Germany Greece Ireland Spain

19. What an economic depression looks like
IMF Report on
Greece, February
2017
Greece has not
managed to return
to sustainable
growth, with output
having contracted
by more than 25
percent since 2008,
investment down by
more than 60
percent, and
unemployment at
the highest level in
the euro-zone.

20. Unemployment is still high in many euro area countries
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Unemploymentrate
EU Euro area

21. 23.1%
18%
12.9%
11.5%
11.6%
10%
10%
9.3%
9.5%
8.7%
8.6%
8%
8.3%
7%
7.8%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Greece
Spain
Cyprus
Italy
Croatia
Portugal
France
Latvia
Euro area
Finland
Slowakia
EU
Lithuania
Belgium
Slovenia
Unemployment rate
Highest Unemployment Rates in the EU
Data is for February 2017

22. 45.2%
41.5%
35.2%
30.4%
28.8%
25.4%
23.6%
16.7%
19.4%
19.1%
19.1%
20.4%
18.8%
20.2%
17.3%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0% 45.0% 50.0%
Greece
Spain
Italy
Cyprus
Croatia
Portugal
France
Bulgaria
Euro area
Slowakia
Belgium
Romania
Luxembourg
Finland
EU
Youth unemployment rate
Highest Youth Unemployment Rates in the EU
Data is for February 2017

23. May 2016 - Deflation in Many Euro Zone Countries
1.6
1
0.6
0.4
0.3
0.2
0
0
0
-0.1
-0.2
-0.2
-0.2
-0.3
-0.5
-0.6
-0.7
-0.8
-1.1
-1.9
-2.5 -2. -1.5 -1. -0.5 0. 0.5 1. 1.5 2.
Belgium
Malta
Austria
Portugal
Finland
Lithuania
Estonio
Germany
France
Euro area
Netherlands
Ireland
Greece
Italy
Slovenia
Luxembourg
Slowakia
Latvia
Spain
Cyprus
Annual % Change in Consumer Prices for Euro Zone Countries, May 2016

24. Inflation in Europe (2nd Quarter 2017)

25. National (Sovereign) Debt in EU Countries
179%
132.6%
130.4%
107.8%
105.9%
99.4%
96.6%
89.3%
89.2%
84.6%
84.2%
83.5%
79.7%
75.4%
74.1%
0.0% 20.0% 40.0% 60.0% 80.0% 100.0% 120.0% 140.0% 160.0% 180.0% 200.0%
Greece
Italy
Portugal
Cyprus
Belgium
Spain
France*
United Kingdom
Euro area
Austria
Croatia
EU
Slovenia
Ireland
Hungary
National debt in relation to GDP
Data is 4th quarter, 2016,
Source: Eurostat

26. Gross Government Debt across the EU
When does government debt
become unsustainable?
Rogoff and Reinhardt argue
that debt above 90% of GDP
can have seriously negative
effects on real economic
growth rates.

27. Yield on ten-year government bonds
8.71%
3.78%
2.29%
2.27%
1.66%
0.92%
0.91%
0.78%
0.5%
0.37%
0.5%
0.25%
0.03%
0.49%
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0% 8.0% 9.0% 10.0%
Greece
Portugal
United States
Italy
Spain
Ireland
France
Belgium
Austria
Finland
Netherlands
Germany
Japan
Luxembourg
Yield

28. Current Account Balance (% of GDP)
Germany and the Netherlands
have further increased their
already significant current
account surpluses. The crisis
countries have also moved
into external surplus but for
very different reasons.

29. The Greek Crisis
Greece inside the Euro Area

30. Greece in 2017
• Real output (GDP) has fallen by 25% since 2008
• Per capita incomes were Euro 18.6K in 2011, now 16K
• Real consumption is 40% lower than pre-crisis
• Unemployment has been above 20% for six years
• Economy remains on the edge of price deflation
• Private sector wages have fallen by more than 40%
• Investment fell to 10% of GDP in 2014 v 27% in 2007
• Tourism is recovering strongly – having the Euro helps!
• But economy has number of supply-side weaknesses
• Interest rate on 10 year government debt = 7.4%

31. Competitive weaknesses for the Greek economy
Fragile banking
system – limited
funds for credit
High rate of
structural
unemployment
Low degree of
economic
diversification
Narrow tax base +
high tax avoidance
Low productivity
and innovation
Shrinking and
ageing population
Most estimates find that Greece’s long run “trend” growth rate is low – perhaps around 1%.
But it is almost impossible to estimate this when aggregate demand is so depressed. The
economy has been de-industrializing for some years.

32. In February 2017, the International Monetary Fund predicted that Greece’s sovereign
debt pile could climb to 275 per cent of GDP by 2060. They argue that Greece is
currently unable to grow her way out of the crisis and that debt relief is inevitable.
Under the deal struck in 2015,
Greece is supposed to achieve a
primary fiscal surplus before
interest payments in 2018 of 3.5%
and maintain this surplus for the
medium term.
Unsustainable fiscal debt?

33. • The TROIKA has imposed fiscal
austerity on Greece
• TROIKA comprises the European
Commission, ECB and IMF
• Fiscal austerity has included:
1. Cuts in public sector pay and
pensions
2. Rise in the retirement age
3. Large scale privatizations
4. Increases in VAT (to 24%)
5. Deep cuts in public sector
employment
“With the drachma, immediately
better" says the hard left union fly
poster on an Athens street.
(Credit: Phil Holden)
Imposed Fiscal Austerity on Greece

34. Internal devaluation in the Greek economy
• Internal devaluation is when a country attempts to improve
competitiveness through lower wage costs and prices
• This is an alternative to a currency depreciation / devaluation
• In Greece there has been a significant reduction in labour
costs – with private sector wages falling by 40%
• A key evaluation point is that prices have not fallen much –
because of sheltered oligopolistic sectors and high VAT
• And Greece does not have a sufficiently large export sector
that sells price-sensitive products to other countries.
“In Greece economic policies of austerity, in conjunction with internal devaluation, have
been adopted in an attempt to improve competitiveness, correct external deficits and
promote export-led growth.”
Source: https://dspace.lib.cranfield.ac.uk/bitstream/1826/11158/1/A_post-mortem_of_austerity-2016.pdf

35. Changes in relative unit labour costs
80
90
100
110
120
130
140
1999 2001 2003 2005 2007 2009 2011 2013 2015
Greece Ireland Portugal Slovenia

36. Would the Greek economy be better off outside of the Euro Zone?

37. The case for Grexit
Benefits
• Chance of export-led growth from a devaluation
• Higher import prices will help domestic producers
• Greece able to inflate away some of their debts
• Greece able to run an independent monetary policy
• Negative real interest rates can provide a monetary stimulus to help
Greece out of a deflationary trap
• End to imposed fiscal austerity allowing the Greek government to
increase their spending
• Some countries such as Iceland have recovered well since their own
financial crisis / currency devaluation

38. Risks from a disorderly Grexit
Risks
• Spike in inflation – affecting the poorest most
• Risk that Greece will turn printing presses on – hyper-inflation?
• Higher inflation will bring about increased interest rates
• Risk of huge capital flight from banks – big risks for depositors
• Likely to be another deep short term slump in real output
• Devaluation comes with debt default - creditors are unlikely to
lend to Greece again at an affordable interest rate
• Greek export capacity is limited – modest gains from devaluation
• Tourism has boomed with Euros - no guarantee this will continue
• May involve leaving the EU and loss of key EU structural funds

39. Where next for the Euro Area?
• Politics takes centre stage in 2017 (Austria, Holland,
France and Germany all have key elections)
• Euro Area is showing stronger (cyclical) growth and falling
unemployment with a reduced risk of deflation
• Is this enough for countries to climb out of the debt crisis?
• Banking systems remain fragile (especially in Italy)
• Eurozone’s periphery is still in deep crisis
• Need for structural economic reforms remains
• Changing centre of global economic gravity is accelerating
• Big risk is that hysteresis effects of collapse in investment,
structural unemployment and impact of rising inequalities
and socio-economic insecurity will damage Europe’s trend
growth and the potential to raise living standards.

40. Monetary Union
Year 2 Macro