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Roles Of The European Monetary Union Economics Essay

A currency is a form of money and is used when purchasing goods or services. Coins and paper money are both forms of currency. There are different types of currency for each country, for example the UK has the Pound (£), the USA has the US Dollar ($) and 15 member states of the European Union use the Euro (€). There are other currencies used all around the world. A person can exchange one currency for another but there is a rate at which it must be done, these are called exchange rates. Exchange rates are the rate at which one currency is worth in another currency, for example at today’s current exchange rates £1 will by a person $1.46. Businesses exchange money every day and in large amounts, this effects how much a currency is worth. Businesses exchange money to purchase goods in other countries, if there are a lot of businesses purchasing from one country their currency value will raise. This means the businesses will have to pay more of their currency to import goods. Even though the value of a currency can rise they can also fall in value as well. This happens when a currency is not in demand. Because the value of the currency is high businesses will not import from that particular country because it will be possible to get what they want from another country for less money. This will cause the value to fall. Even though people exchange money when going on holiday they do not play a big part in exchange rate fluctuation, it is businesses which cause the exchange rate of countries to change every day. The exchanges rates have two effects on businesses. One of them is that businesses need them to import and export goods to other countries, without them it is not possible because each country has a different form of type of currency. The other impact is that businesses make the exchange rates fluctuate making it more expensive or cheaper to purchase goods in other countries.

Pound Sterling - United States Dollar

Fig 1

This graph shows how the pound has fallen in value against the US dollar over the past year. It shows that in January people where able to get $2.05 for a £1 and now they are only able to get $1.46.

Pound Sterling - Euro

Fig 2

This graph shows how the pound has fallen in value against the Euro over the past year. It shows that in January people where able to get €1.40 for a £1 and now they are only able to get €1.17.

Euro - United States Dollar

Fig 3

This graph shows how the Euro rose in value against the US dollar from January to July then fell quite steeply till the present day. It shows the value of the Euro peaked at €1.60 for every dollar, but fell to €1.26 in November.

The US dollar started to rise in value quite swiftly against the Euro and the Pound between July and September causing the value of the Euro and the Pound to plummet to all time lows.

Before the euro was introduced the member states of the EU still used their own currencies, but the exchange rate of these currencies were always fluctuating. Following an Arab-Israeli war in October 1973. Middle Eastern oil production companies forced high prices and restricted sales to certain European countries, consequently this created economic problems throughout the EU. This gave birth to the European Monetary System (EMS). The EMS was an arrangement between the member states to link their currencies to prevent large fluctuations. The essential fundamental of the arrangement was the creation of the exchange rate mechanism (ERM) which was a system to help maintain stability for the currencies of the member states. This was done by setting limits an exchange rate could fluctuate in. The limit was 2.25% (6% for Italy), for example the pound’s exchange rate could not increase by more than 2.25% and could not decrease by more than 2.25%. All currency values within the EU were tied to the German mark because at that time their currency value was the Strongest. This was good economically because business could cope with small fluctuations. But what happened when a countries exchange rate reached its limits? This happened in September 1992 when the UK was forced out of the ERM. The value of the pound was decreasing and the government tried to keep the value within the ERM limits. They raised interest rates from 10% to 12% to 15% in one day and they spent large amounts of other currencies to buy pounds to try and increase the value of the pound. But it did not work and had to leave the ERM. Other currencies in the EU devalued and the French franc was the only currency to successfully defend itself from devaluing. The establishment of the ERM was the first time a single currency was thought possible.

The signing of the Maastricht treaty in 1992 was when the EU made it an objective to bring a single currency (The Euro) to pass. The euro was launched in 1999 but only for commercial and financial transactions. Notes and coins were introduced in 2002.

There were strict conditions to be met before a country could ascend to the euro. These included targets for inflation, interest rates and government debt. A European central bank was created to set interest rates for all member states that ascended to the euro.

With the ongoing integration between the members of the EU and the continuing effort to make the trade of goods, services, people and capital easier, it was only a matter of time until the euro was launched. The ERM was designed to maintain the stability of exchange rates within the EU and was not very successful in doing this, so the EU had to come up with a better idea. This was the euro; this would remove the exchange rates when trading within the EU and make things more simple because businesses didn’t have to worry about how much their currency was worth in another currency within the EU. This is also written on http://www.civitas.org.uk/eufacts/FSECON/EC9.htm, it says

“Yet it was not an entirely successful move because it posed many technical difficulties in setting the correct rate for all member states and because some members were less committed to it than others”

Introducing the euro was inevitable because the ERM was not very successful in keeping all the exchange change rates within the EU stable and it was an objective for there to be a free movement of capital (money) between the member states of the EU. If there is to be a free movement of capital between the EU they would have to do away with exchange rates and create a currency for the member states to use.

There are 5 economic tests for the UK to join the Euro. These were created by the Chancellor of the Exchequer in 1997, this was Gordon Brown. The tests are a set of conditions the UK has to pass for it to join the Euro. The key notion behind the test is whether the UK is able to handle the same monetary policy as the countries within the Euro zone. The first test is economic harmonisation. If the UK joins the Euro the UK will be in sync with the Euro zone. But if the UK was growing at a faster rate than the EU then the UK interest rates would have to be increased but then that would increase the interest rates of all the other countries within the Euro zone. This is because the interest rates in the Euro zone are controlled by the European Central Bank. But if there were harmonisation there is no guarantee that it would be on a permanent basis. The second test is flexibility and whether there would be enough of it. For example if the UK went into a recession would it be able to cope. The UK would have no authority over monetary policy and fiscal policy would be limited by the growth and stability pact. This would restrict the amount of government borrowing and consequently restrict the scale for expansionary fiscal policy. The third test is investment and the effect the Euro will have on it. Would the Euro create a better setting for firms making long-term decisions to invest in Britain? The fourth test is financial services and what affect the Euro will have on it. What influence would the Euro have over the financial services industry considering London’s financial sector has thrived in recent years would the Euro effect it in a bad way? The last test is growth and employment. Will the Euro encourage higher growth and stability? Also how will it affect employment, will it create a permanent increase in jobs or not? There is no evidence that it would.

With all this said will it be in the national interest for the UK to join the Euro? There are advantages to joining the Euro. The advantages are, the Euro would end currency instability within the Euro zone and lower it outside it because the credibility of the Euro would increase because it is being used in most of Europe. Another advantage is people travelling from the UK would not have to exchange their money, encountering fewer restrictions when transferring large sums of money when going across borders. A further advantage is businesses won’t have to pay hedging cost to insure themselves against the threat of currency fluctuations. Another advantage is there will be a lower interest rate. Also the stability pact will force EU countries into a system of fiscal responsibility. This will enhance the Euro’s credibility, which should lead to more investment, jobs and lower mortgages. Even though there are advantages there are also disadvantages to joining the Euro. The disadvantages are, if the UK government is required to conform to the stability pact they may be unable to battle a recession using fiscal policy. This is because the government will not be able to borrow as much money or cut taxes. Another disadvantage is the UK will have no control over interest rates as the European Central Bank controls interest rates within the Euro zone. A further disadvantage is the UK will lose its sovereignty. This means that the UK will have to work with other economically weaker countries, which are more tolerant to higher inflation. Another disadvantage is that the transfer between the pound and the Euro will cost a great deal. The British Retailing Consortium estimated that all British retailers will have to pay between £1.7 billion and £3.5 billion to make the essential changes. These changes include educating customers, changing labels, training staff, changing computer software and adjusting tills. The last disadvantage is the exchange rate would no longer balance Britain’s trade and capital flow with the rest of the world.

It is difficult to say if it would be in the national interest of the UK to join the Euro as there are advantages and disadvantages. But nobody knows what will happen if the UK joins the Euro, we can only predict possibilities. It is wrong to say the UK will never join as there are advantages to joining the Euro but the UK will not be joining anytime soon.

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