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Is Uk Ready To Adopt The Euro Economics Essay

Literature review

If we are to have any confidence in the findings of this study, it is necessary that we begin with a solid theoretical framework and an understanding of some economic theories related to research questions. According to the literature review, there is huge theoretical and empirical evidence related with microeconomic policy and monetary harmonisation which identifies and reveals numerous issues that are critical when discussing the readiness of group of countries for single currency creation. Some economics theories which are underpinned to find out the central question are discussed briefly below.


The theory of OCA was pioneered by Robert Mundell in 1961. This economic theory offers to analyse the conditions for reducing the costs and maximizing the benefits of forming or joining a monetary union. The country is said to be optimal currency area when similarities between the economic structures of countries make it feasible to adopt a single currency. There are numbers of single currency areas all around the world in the form of integrate and pegging system. European Union and Caribbean dollar are the successful example. Adopting single currency decision is always complex and often based on countries specific political, economical and historical roots. Adoption of Deutche Mark in 1990 by Eastern Germany (, poor economic condition of El Salvador ( ) and historical roots of Hong-Kong (pegged with US dollar) ( ) respectively are the good reference for this complexity.

According to the literature, OCA theory can be laid down in two dimensions. The first dimension tries to find the economic variable to determine where the boarders of the single currency should be drawn. The second dimension believes that any single country can be an optimal member of a monetary union if they fulfil the requirements. After World War 2, when the exchange rate regime established countries reluctant to think about both of the facet of OCA. USA than allowed its dollar to easily convertible to a fixed amount of gold to make its currency more stable. As a result, many countries noticed us dollar as a stable currency and therefore either adopted it or pegged the value of national currencies to the US dollar.

However, the concept of fixed exchange rate received a lot of attention but there were also some researchers like Friedman (1953) who stated that the only country can cope with the exogenous shock that have flexible exchange rate. Later this hypothesis used by Mundell (1961) to develop the OCA in which he stated that the creation of single currency based on the two factors mobility that is external and internal. Mundell’s OCA theory received a lot of criticism because of unrealistic and simplistic assumption for instant Philips curve which were used to develop that have been criticised in 1960-1970’s. Mc Kinnon also argued that the OCA model is full on neo- Keynesian theory.

The cases for joining the EURO-

In the essence the argument is that why the UK should join the euro. Numerous cases have been already discussed by various economists. Djflsf is one who published the case against and for adopting the EURO.

To figure it out one side the five tests were designed by former British labour party chancellor Gordon brown in 1997 for assessing the entry of Britain’s into the EMU. The membership of EMU means that the UK would adopt the EURO as its currency and UK interest rates would be set by the European central bank (ECB). This can be done by evaluating economic conditions and the interest of the British people. The five tests were-:

1. Whether there can be sustainable convergence between Britain and the economies of a single currency.

2. Whether there is sufficient flexibility to cope with economic change.

3. The effect on investment.

4. The impact on our financial services industry.

5. Whether it is good for employment.

Another benefits for single currency is elimination of exchange rate between euro and pound. This considered as a core argument for going into EMU. The elimination of exchange rate promotes trade with Europe, trade further increase foreign investment in UK and will reduce the cost of capital.

The main argument issuing around the single currency criteria is an increase in the volume of trade. Trade is an interest primarily factor for an economic growth. The international trade theory strongly believes that “increased openness can increase productivity and hence real output and incomes”. In today modern world with latest technology the transportation cost reduced and with further elimination of exchange rate promotes trade. Meanwhile, foreign investment in UK will boost and the cost of capital will reduce. Those all means that, the trade among the integrated countries likely to boost. The HMT treasury stated that, “Our assessment makes clear that, with the advent of the single currency, trade within the euro area has already expanded and that, with Britain in the euro, British trade with the euro area could increase substantially - perhaps to the extent of 50 per cent over 30 years.”

The rose finding is that, the currency union seemed to have a large effect on trade. “One of these studies concluded that the member of currency union traded over three time as much as otherwise similar pairs of countries” ( ).

As the volume of the trade in intraregional increases, the case for economic divergence decrease. Which means every countries economy would become more likely each others. Meanwhile, the asymmetric shocks reduced (Horvath et al, 2002, p. 15). Simultaneously, the sign of business synchronisation emerge which leads to greater integration between countries. Furthermore, to access in greater integration especially when integration take place due to the transportation cost, the accessing countries should be specialised in goods and services to get benefit for the long term period (Krugman 1993). Significant signed has been noticed that “the European market is changing Europe’s economic contours, with counties specialising in the sectors where they have a comparative advantage” (Elliott, 2008). Since financial sector of the UK is the comparative advantage. If UK joins EURO ZONE, it would access more integrated European capital market than now.

the reasons that why UK decided to not join the Euro Zone were interest rate and lack of convergence in economic. The UK interest rate was substantially higher than EU during HM first assessment. After that significant efforts were shown to meet the EU criteria to allow the UK to join. According to the Gordon brown statement “we have pursued since 1997 – an independent central bank, new fiscal rules, lower debt, housing market reform, greater flexibility in labour, capital and product markets including an independent Competition Commission – have contributed to meeting, quite comfortably, the Maastricht criteria for nominal convergence – in a better position than some current members were in 1997 and even are now – but are also leading towards the sustainable convergence and greater flexibility required by the five tests.” ( ). Currently if we look at the economic convergence and interest rate figures then we can find out that both legal formalities are already met since 2003. The only reason for not joined is that “we were not sure whether this rate of convergence relevant for long term or not”. The core element included is housing market and inflation rate which was the solid key factors against the EURO. However, the sub-prime recession fully vaporised both obstacle. Resulted, fear for loss of competitiveness due to high inflation rates for UK reduced. Correspondingly, the value of UK and Euro is very similar because of collapse in UK pound strength. That means, the convergence has been achieved as shown in chart below-:

Cyclical Convergence UK and Euro zone 1998.06 - 2008.10

Cited by Buiter (2008).

Similar convergence can also be observed in the interest rates (Figure 2).

Long-term real interest rates in Euro zone and UK 1994.01 - 2008.10

Cited by Buiter (2008, p.6).

Another thing left unsolved during HM treasury test was housing market. Housing market in the UK was much stronger than the rest of the EU. But recently global financial crises collapse the UK mortgage market. The housing market stood at the bottom level as compared to the past experience (BoE, annual report 2008). Respectively, the argument for housing market coincides between UK and EU also does not hold much value than before. “The UK model of housing finance is broken. Measures to encourage truly long-term fixed-rate financing (20-year or 30-year fixed rate mortgages) are long overdue. New mortgage financing has collapsed, the securitisation of new mortgages has grounded to a halt, and the construction sector (residential and commercial) is teetering on the brink of disaster” (Buiter, 2008, p.7).

If UK adopt the euro currency that means they have to demolish their local currency (Pound) and hence stop floating against the major competitor the EURO. It has been already discussed extendedly by many economics whether adopting Euro will be beneficial to the UK or not (Minford, Artis, Buiter). The core argument for all these studies was “floating exchange rate”. Is floating exchange rate should be better equipped to adapt to economic shocks? This is complex in nature and sometime in certain cases it is true though for example, floating exchange rate enable the countries to dampen the impact of shocks and hence allow economy to` recover more rapidly than others. Although, the benefits of monetary autonomy still be present if the exchange rate is driven by non- fundamental factors. The factors that drive the exchange rate enable to confer on the central bank autonomy to determine the existing amount of base money and use that as a policy instrument by setting domestic short term interest rates (DiCecio et al, 2009, p.6). It has been already presented by corsetti al (2007) in his model that the in the case of preventing shocks both floating and fixed exchange rate fails equally adhere to fundamentals.

Is UK unwilling to join EMU just because they consider the floating exchange as a benefit tool for economic prosperity or because they afraid from the past experience to repeat again which they had in 1992? DiCecio et al, (2009) concluded that if UK joined the Euro area they still felt the different economic shocks as they fell now via different channels. They also concluded that the economic stability also diminishes under monetary union if goods are imports from euro area as primarily intermediates instead of finished goods.


Let me recapitulate by making four strong statements:

Transportation cost

Literature of single currency reveals three main benefits: reducing in transaction costs, elimination of exchange rate risk, and increase transparency in price comparison. But the question arise here “is that all benefits react same to different countries?”the answer is No, the benefits of single currency depend on the country’s economic specifications. For instant, Transaction costs saving would be higher for under developing countries than developed countries because of low level of financial flow. So, the country like UK with having advanced banking system would save less as compared to other countries but even still UK can save around .01% of GDP (Minford, 2002). The reason for less saving in transaction cost is the vast proportion of currency exchange between pound and euro transactions held in banking system in the form of intra trade payments. Although, this vast majority of banking system also make a plus point to save transaction cost for UK by implementing one extra operation in banking system to convert a transactions of payment into another currency. That would be essentially at zero marginal cost. Practically the cost would occur only in hand to hand conversion basically in small tourist transactions. The assessment of HMT in 2003, also stated “We estimate that the transaction cost for business and consumers as worth around 0.1 to 0.2 per cent of GDP, £1 billion a year, the gains greater for smaller companies and the gains permanent.”

Apart from above two advantages, transparency of price comparison is one of the major advantages of single currency. Single currency makes easier to compare prices because consumer will gain price similarity all over the Europe.

Why shouldn’t the UK join the EURO?

With delivering extensive benefits to the participating economies, single currency also imposes costs. According to the McKinnon (2002), the major reasons why a country should not join single currency are: loss of monetary autonomy in response to asymmetric shocks and unstable monetary standard. McKinnon stated that “in the world there is no sufficiently stable monetary standard”. The national government of the countries reluctantly give up its sovereignty if they tie up with single currency. Immediately entry would impose numerous economic shocks and that would affect on economy as a whole. UK designed five economic tests to successful entry into EU which have been discussed in next section.

Loss of the control over the monetary policy is the one of the main arguments issuing around that why the UK should not join the EU. Monetary policy are jointly controlled by the countries with having only one single currency which means if exogenous shocks occur in any country they will not be able to protect itself via shifting its interest rates or exchange rates. Indeed, Due to the linkage to the dominant trading partners, the Single currency can provide the necessary stability normally for the smaller open economies. Contrary, for the UK to be linking with other dominant countries would be pointless because it will also taking the exogenous shocks of smaller economies.

Although, it does not necessary that joining monetary union means the end of the independent fiscal policy for its member states. The fully monetary union countries can keep their fiscal policies independent. However, in order to adjust the asymmetric shock in common currency area, some centralised decision could need to be achieved. Typically, centralisation budgets often imposed to an increase in spending. (hv). Clearly, The UK has no reason to fear for any type of reduction in fiscal policy by joining the Euro zone to manage its national economy (buit).

The Loss of control over seignorage is also important to mention because it assumed to be an important source of fiscal revenues and it is often argued to be a major disadvantage of adopting single currency. Literally, no hard concept is applicable for measuring seignorage . Eventually, the choice of concept is depends on the specific environment in which base money is created. Due to this, the fiscal concept is considered as a most general concept for measuring seignorage (seig). Theoretically, to fight against the increasing debts, the government should not opt out for printing money because this leads to increase in inflation. However, in practice, the volatility of economic cycles pushes country economy into critical recessions. At that stage, government reluctant to look over seignorage to fix problem as early as possible before the economic totally collapse. For example the “sub-prime mortgage recession” in US combined with budget deficit forced the US government to print money to avoid their economy collapse. Aftermath, the sub-prime mortgage recession triggered the financial crises all over the world. UK also pumped half of billion in the economy for recovery hope ( “Should the UK join the EU”, this option was also available for UK but due to the risk of uncertainty in economic recovery and imbalance between economically and politically reasons, this option halt to the ground.

Apart from the sovereign, the volatility of exchange rates also has negative effects on economic calculation. However, this volatility helps to the stock market to make huge money. Furthermore, during the sub-prime recession period until it hits to UK financial sector, UK consumers enjoyed a higher welfare gains than any other USA or European countries because of strong position of pound. But if there is uncertainty in exchange rate, the expected profit of investment will be low which could lead positive effect on output. Hence, theoretical outcome related to volatility of exchange rate is ambiguous (Horvath et al , 2002 p 14).

Among the countries if the economic cycles are synchronized, the chances of asymmetric shocks increase. Mostly, European countries (especially industrial countries) are doing intra industrial trade based on economies of scale and imperfect competition. That allows countries to increase trade without increase in specialisation growth. Hence, the asymmetric shocks likely to decreases (Harvath et al 2002 p 15). Also, if Krugman’s argument becomes true then, those shocks may become more severe. Countries then need to be specialised in goods to cope with shocks. Furthermore, those shocks expected to strike on concentrated areas which already have a strong bonding to cope. Correspondingly, the problem with Krugman’s view is that it implicitly assumes that regional concentration of industry will not cross the borders of the countries that formed the union, while borders will be less relevant in influencing the shape of these concentration effects. If so, then asymmetric shock is not country specific and floating exchange rate variation could not be used to deal with asymmetric shocks anyway” (Horvath et al, 2002, p. 16).

“The second is diminished exchange rate volatility, with gains for both large and small companies especially in the manufacturing sector with again potentially the greatest gains for smaller companies.” ( )

the attractiveness of fixing or pegging the exchange rate , rather than adopting a more flexible policy, also depends on whether there is a natural candidates for a currency to peg to.

Stable exchange rate is the strong properties of any countries

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