The Current Exchange Rate Regime in the European Union - Essay Example

?i) The current exchange rate regime in the European Union European Union uses Exchange Rate Mechanism (ERM) called semi-pegged currency system, which is based on the concept of fixed currency exchange rate margins. It uses euro as an anchor currency. This is because euro is perceived as a safety measure that protects currencies in the euro zone from currency shocks. The semi-pegged currency system dictates that all governments forming the European Union keep their currencies within a specified range. It stipulates that no currency of any given European Union member should fluctuate beyond 2.25 percent from the agreed and set central limit. The normal fluctuation rate dictated by ERM is + or – 15 percent. However, countries that are able to maintain very high degree of convergence to the Euro can negotiate narrow fluctuation band (range). For example, Danish fluctuation rate has been allowed a narrow range of + or – 2.25 percent because it was able to maintain excellent convergence to the euro. The main reason of controlled currency fluctuations is to minimize foreign currency risks caused by high and sudden currency value fluctuations. Stabilization of the national currency through pegging system helps to promote trade by minimizing trading barriers. Trade barriers (increase in currency exchange costs) result from sudden fluctuations in foreign currencies that may increase cost of doing international business. Pegging currencies in the euro zone was aimed at speeding up the adoption of single market. In the event that European Union member currency surpasses predetermined currency fluctuation range, the European Central Bank and the central bank of that nation should intervene by fixing foreign exchange rates consistent to country’s economic needs. This is in a bid to ensure that the exchange rates are kept within the fluctuation range. The European Central Bank can advance short term loans to rectify currency fluctuations in the short run caused by instant speculative pressure. However, short term interventions by The European Central Bank can be suspended if interventions contradict with objectives and aims of both the European Central Bank and country’s central bank. Membership to EMR II is not mandatory but is a prerequisite foe any country, which wants to join the euro zone. No country will be admitted to euro zone until it participated in EMR II for at least two years with no severe tensions and devaluations. ii) Advantages and disadvantages of resulting from agreements with EU to Peg the Pound to the Euro and join the European Monetary Union a) Pegging the Pound to the Euro When a country is pegged to a euro, movement in the euro is followed by movement in the currency associated with it. There are some advantages associated with pegging the pound to the euro. First, the euro is becoming popular. Euro has become favorable international currency for most governments. Most countries outside the euro zone have already pegged their currencies to the euro and are enjoying financial stability. Euro provides shelter against unexpected drops in individual currencies. Bulgaria, Estonia, Lithuania, Bosnia, Herzegovina and Cape have not adopted the euro but have pegged their currencies to the euro. This makes the euro stronger and stable. Secondly, pegging pound to euro will reduce pounds’ fluctuations (shocks). Pound will gain strength and stability as euro gain strength. According to Ghosh et al (2002), pound will achieve more clarity, transparency and predictability if pegged to the euro. This is because currency pegging imposes necessary discipline when country is dealing with foreign exchange currencies. Third, pegging pound to euro helps to enhance pound’s credibility. Credibility will be achieved when pound is pegged to euro, which has lower and increasingly predictable rate of inflation. There are disadvantages associated with pegging pound to the euro. First, pound is likely to lose value when euro loses value. This is because changes in anchor currencies will affect associated currencies in equal measure. Second, United Kingdom will need more euro reserves to defend the pound. This could be expensive and impractical when United Kingdom will be trading more with countries such as Japan, China and the United States. Thirdly, United Kingdom Central Bank will lose its sovereignty. United Kingdom will not be able to fix its exchange rates in response to its domestic needs. In stead, it will have to take a long and painful process of seeking permission to adjust its exchange rates. This may be delayed and its economy will be adversely affected. Fourth, United Kingdom will be faced with currency exchange rate rigidities. Fratianni et all (1999) argued that pegging one currency to another cause a lot of rigidities. Thus, United Kingdom Central Bank will not be in a position to achieve changes in currency exchange rate at the speed it desires but will have to wait for decision to be made by member states. (b) Join the European Monetary Union There are many advantages derived from joining European Monetary Union. First, individual countries will eliminate transaction costs caused by foreign exchanges fluctuations. Firms in the United Kingdom spend billions of pounds yearly to buy or sell foreign currencies as they transact business in the European Union. Single currency will eliminate foreign exchange transaction costs and increase trade. Secondly, individual countries within European Monetary Union will eliminate Exchange rate fluctuations uncertainties. Different currency increases uncertainties on the possible fluctuation of currencies. Thus investment will rise if single currency is adopted. Third, members of the European Monetary Union will enjoy greater price transparency. Distorting effects of exchange rate differences makes it extremely difficult for firms and households to compare resources, goods and services across the European Union. Single currency saves energy and time that could have been used to convert one currency to the other. This makes trade easier among member countries. Fourth, members of the European Monetary Union will be more competitive in business. The American dollar and Japanese Yen are strong because United States and Japan economies are stronger due to millions of inhabitants. A single new currency in Europe could make Europe’s currency and economy stronger. There are disadvantages associated with joining the European Monetary Union. First, members of the European Monetary Union will lose individuals sovereignty. Every European Union member country looses its power to control monetary policy because power to make decisions will be transferred to The European Central Bank in Brussels. Secondly, European Monetary Union benefits have been overestimated. Some economists have argued that cost and trade benefits have been over estimated and that little will be gained as compared to the current situation. In addition, European Monetary Union will bring with it substantial rigidities that will make it more difficult to trade between countries as before. United Kingdom and Italy left European Monetary Union in 1992 because the system was less robust than they believed. Thirdly, European Monetary Union can make euros’ macroeconomic environment unstable. For example, United Kingdom experienced prolonged recession period between 1990 and 1992 because ERM adjustment mechanism was like that of the gold standard in the euro area. In addition, higher inflation in one member country is likely to generate current account deficits and pull its currency down. When United Kingdom left ERM and cut its interest rates to 5%, its economy grew strongly and current account position improved significantly. Bibliography Ghosh, RA., Gulde, A & Wolf, CH 2002, Exchange rate regimes: choices and consequences, Volume 1, MIT Press, Massachusetts. Fratianni, M, Salvatore, D & Savona, P 1999, Ideas for the future of the international monetary system, Springer, Germany. Read More