The Euro started Jan 1999

EMU involves

Replacement of National currencies by the EURO
Same Monetary Policy – Since “One Money” implies uniform interest rates
Exchange Rates within the Euro area will cease to exist
By mid 2002 national currencies will cease to be legal tender

Pre Launch Blues

Expectations about Inflation helped reduce actual inflation rates in countries such as Italy, Belgium and Ireland who traditionally had high rates of inflation.
Many Countries fudged the fiscal criteria. Some people believe high budget deficits are likely to lead to inflation and higher interest rates.
Several states resorted to a one off tax increase If a govt has to use fiscal policy to reduce budget deficit this can harm the economy, especially with the pension time bomb looming

European Central Bank In Action

Sets policy targets
Sets short term interest rates which determine rate of growth of money and credit
Price Stability is its primary goal ( It aims at less than 2%)
In pursuing this objective it will look at “Two Pillars
- Broad Money Aggregate M£
- “Broadly based assessment of price stability based on inflation forecasts) This is known as inflation targeting.

In 1999 THe ECB cut interest rates to 2.5% in response to low inflation
In autumn 1999 they raised interest rates against
- rising oil prices
- a further slide in the Euro value
- overheating US economy
- Above target growth of M3
The ECB was under political pressure to have lower interest rates for Germany but this was ignored

A Weak Euro

It was expected that the Euro would be a strong currency because of the low inflation heritage from the D Mark and the Commitment to price stability in the Maastricht Treaty
It was expected that the Euro would in time come to rival the Dollar as an international trading currency

The Euro fell by 16% against the Dollar in 1999, The fall was slightly smaller against a basket of currencies (13.5%). The weakness of the Euro can be explained by the following

- The strength of the Dollar
- Difference of cyclical positions in the EURO and US economies, Us had faster growth and higher interest rates, but inflation was still low. Real interest rates are much higher in US leading to “hot Money flows”
Increase in Govt borrowing s financed by EUROS
Increase in private Euro debt borrowing as private corporations are crowded in by decreasing govt debt

Is the Weakness of the Euro a problem?