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Euro currency convergence criteria

Question 2 (c).

The Euro currency convergence criteria are the criteria for European Union member states to enter the third stage of the European Economic and Monetary Union (EMU). The 4 mains criteria based on Article 121(1) of the European Community Treaty are price developments/ inflation rates, fiscal developments/ government finance, exchange rate developments and long-term interest rates development.

Price developments/ Inflation rates

Under this criteria, the inflation rate of any of the member country cannot be more than 1.5 percentage points higher than the average inflation rate of the three best-performing (lowest inflation) member states of the European Union.

From Figure 2.1, the three best-performing countries are Kyrgyzstan (6.4%), Uzebekistan (7.6%) and Kazakhstan (9.5%) gives an average inflation rate of 7.83%. Since the inflation rate of the remaining 2 countries; Taijikistan and Turkmenistan are 11.9% and 13.8%, the difference in the inflation rate far exceed the minimum 1.5% difference under the Euro criteria.

Fiscal developments/ Government finance (Financial Position)

The annual government deficit to gross domestic product (GDP) ratio must not exceed 3% at the end of the preceding fiscal year. At the minimum, it has to reach a level close to 3% and only in exceptional cases, would exceptional and temporary excesses would be granted.

In addition, the gross government debt to GDP ratio must not exceed 60% at the end of the preceding fiscal year. Should this target cannot be met due to specific conditions, the ratio must have sufficiently decline and approaching the reference value at an acceptable pace. A country's stability and its ability to finance itself is gauge from this ratio and differing ratios will impact the country's ability to invest in its productivity and growth. When countries within the same zone have different productivity and growth rates, the weaker countries will risk being cannibalized by the stronger ones. As seen from Figure 2.1, Kazakhstan and Kyrgyzstan are both facing this problem.

Exchange rate developments (Sustainability)

Under this criteria, it is a prerequisite that applicant countries of the union have to join the exchange-rate mechanism (ERM II) system which is under the European Monetary System (EMS) for consecutively two years before they may be qualify to be in the union.

It is important that this criteria exist as currency devaluation may cover up actual problems with the economy, making imports appears costly while exports looking cheap and affordable.

Long-term interest rates development (Stability)

The nominal long-term interest rate cannot be more than 2 percentage points higher than those of the three lowest inflation member states. As interest rates have an effect on an economy's growth, it can drive funds out from low interest markets to higher interest rate markets for greater returns if the interest rates are different between economies.

In conclusion, based on the Euro convergence criteria and the current financial situations of the Central Asia five nations, creating a similar exchange rate mechanism or a common currency is not feasible due to instability and financial imbalances. The Turkmenistan central bank governor should implement more stringent regulations on currency control and set to work on the black market rate. In the long run, with the currencies and trade of all five nations under control, there will be an equilibrium where the inflation rates, currencies and interest would be on par where the implementation of an exchange rate mechanism or common currency would be achievable.

Question 4 (a) Identify and explain the important features of the Loanable Funds theory.

Loanable funds theory is that of determining an interest rate, explaining the causes of its rises and falls, which perceive equilibrium of interest rates in financial markets as a result of the supply and demand for loanable funds.[1]

Savers provide the loanable funds, while borrowers demanded them. For example, savers supply loanable funds to institutions, which can be a government or a firm when they purchase bonds from them. On the other hand, if an institution sells a bond, it is demanding loanable funds.[2]

From Figure 4.1, the demand curve represents the borrowers' demand for credit (DC) and the supply curve represents the lender's supply of credit (SC). We can observe that when the real interest rate (r) increases, savers will save more, causing an increase in the supply of loanable funds while at the same time, borrowers will reduce their borrowing which leads to a decrease in the demand of loanable funds. This shows a direct relationship between the supply and demand of loanable funds and the real interest rate.

The market for loanable funds is the market that brings savers and borrowers together[4] and the price that brings the loanable funds market into equilibrium is the real interest rate[5], which is the nominal interest rate minus the expected rate of inflation, and this is what savers and borrowers care about.

As shown in Figure 4.2, an increase in the supply of loanable funds at every available interest rate shifts the supply curve from S to S1, which causes disequilibrium between supply and demand. As a result, the real interest rate will drop from R to R1.

Conversely, when there is an increase in the demand of loanable funds, the demand curve shifts from D to D1, which again causes disequilibrium between supply and demand. As a result, the real interest rate will climb from R to R1.

Interest rates are only one of several factors affecting the supply and demand of loanable funds. Other factors influencing the supply and demand of loanable funds are shown in the 2 tables below:

Besides interest rates, we had mentioned earlier about the existence of other factors such as total wealth, monetary supply expansion, economic conditions, near term spending needs and risk of financial security, which causes the shifting of the supply curve at any given interest rate.

Hence, in order to increase the demand for domestic bonds, the central bank of Turkmenistan could stimulate economic activities by cutting interest rates and boosting loans. In addition, there are several ways to increase demands for government bonds.

One method used by the United States government is the implementation of monetary policy. Through this method, the availability of funds are altered which affects the growth in the money supply which thus influence the economic expansion rate. While the equilibrium interest rate falls, the equilibrium quantity of traded funds increases. And with lower interest rates, financial institutions would be able to demand more credits from funds suppliers.

Another method of increasing government bond is through changes in taxation. Bond markets are sensitive to transaction costs, and taxation policies can create barriers to demand. Hence, mandatory tax-effective savings (E.g. Superannuation, which is Australia's compulsory retirement scheme) could be implemented by the Turkmenistan government to enhance demands for government bonds. In addition, doing away with financial transaction taxes and allowing exemption from interest withholding taxes will give the corporate bond markets an extra boost.



eHow - The Loanable Funds Theory

The Loanable Funds Model