International Finance Issues - Assignment Example

?(a) Optimum Currency Area and its relevance with Euro Area: The idea of a single currency to trade in a certain geographical area is not a new one. The theory of “Optimum Currency Area” was presented by the American economist and the Noble prize winner Robert Mundell in 1961. An Optimum currency Area is said to be an area comprises of separate countries or states with a single currency. With the help of this theory, a single currency is supposed to help in reducing trade obstacles among neighbouring countries. Robert Mundell also presented criteria for a union to be an effective monetary and economic union i.e. in order for an economic union to be successful it is necessary to have following conditions among the member countries: 1. Labour mobility: Labour mobility is the free access to labour without any legal or cultural obstacle, and having similar wages and other employment conditions. 2. Capital mobility: It will allow the market forces to enhance the equal distribution of wealth and resources through supply and demand. 3. Similar Business Cycle: It will help the member countries in reducing inflation and increasing growth. 4. Automatic Fiscal Transfer Mechanism: It will help in redistribution of money towards less developed areas without federal interference. As of today, the European Union is comprised of 27 member countries having an aggregate population of around 500 million people. Making an economic union was a very bold and risky step for European countries. It involved not only the compromise on the individual monetary freedom of the member countries but also the integration of central banks. The basic purpose of this unification was to give economic support to member countries through the integration of economic and political policies. In order to enhance the importance of Europe in the monetary mechanism of the world, there was a need of unity among European countries. In order to follow the example of the United States single currency mechanism, the need of single monetary and trading was increasing after the crisis of 1969. At the time of foundation of European Union, the member countries established European Steel and Coal Community, European Economic Community and European Atomic Energy Community. However there were still barriers in the path of perfect mobilization of capital and labor. The European Union was officially created on 1st November, 1993 under the third Delors Commission. The Euro was introduced initially in a non-physical form like EFT or travelers cheques in January 1999 and captured the market completely in physical form on 1st January 2002. In contrast to the economist expectations, Euro survived a good length of time. It was the first experiment of its kind in the history. Many economists were skeptic about the future of Euro and its corresponding impact on European economic future. Several criticisms rose as to the applicability of the Optimum Currency Theory on European Union due to the lack of mobility of factors of production among member countries. US economists objected that European Union is not so integrated to issue single currency like the different states of US. However they overlook the fact that it took more than 150 years to United States to integrate the monetary system of all states by issuing Dollars for the entire nation. However the theory of optimum currency area does not include political economy factors like the desire for European integration on political level, reducing the exchange rate risks and achieving stable price levels. US economists also believed that the entire European monetary integration was basically a political ploy and therefore lacking the necessary criteria of the optimum currency area. On the basis of the crisis of European Exchange rate system in early 90s, they begin to suspect the viability of this monetary union. From the very beginning of the European monetary integration process, this union is always question on the basis of the optimum currency area theory. The basis of all criticism was that the Europe was not at all an optimum currency area. Moving forward towards perfect mobilization of factors of production, European Economic Community had introduced Schengen Area, an area comprises of 25 member countries operates as a single legal territory or state for the purpose of travelling without any internal border controls. As a customs union, European Union also removed custom barriers among member countries and applied a single customs policy for non-member countries. Further, no member country can impose tax on the goods or services of the member country except the tax charged on the similar nature domestic products under the Treaties of the European Union. Apart from these, the citizens of the European Union member countries can move without restrictions for the purpose of residence, working or living among member countries. The transfer of money from one country to other inside the European Union is also charged as per domestic rates and so as ATM withdrawals in order to promote capital mobilization. European Union is taking several steps for the perfect mobilization or freedom of factors of production among its member countries. However European Union involves separate countries and their separate political issues unlike United States. Further the member countries of European Union have extremely dissimilar economic circumstances again unlike United States. These two factors are big obstacles in the way of complete European monetary integration and several economists still doubt that whether European Union can ever be an optimum currency area or not. (a) Euro-zone and the fixed exchange rate mechanism: During the Second World War, there was an urgent need to rebuild the international monetary and economic system. In July 1944, the Bretton Woods Agreement was signed by all the Allied nations to promote monetary cooperation among countries. The Bretton Wood Conference concluded the establishment of the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (IBRD) to govern and supervise the monetary issues between the nations. The main obligation enforced by the Bretton Wood system on the participating countries was to follow a certain monetary policy to maintain exchange rate defined in terms of US Dollars with a fixed dollar price of gold. In other words, it was a gold exchange system that was backed by dollar as primary reserve. The growth of dollar and the economy of United States were all due to the Bretton Wood Era. The U.S. dollar was the highest purchasing power currency and was the only currency backed by the gold. Due to the circumstances of the Second World War, the majority of the European countries were highly in debt to the United States and soon a large amount of gold was transferred to the United States. The U.S. dollar was highly in demand and the state banks of different countries started to pile up the reserve of dollars that led the downfall of dollar during 70s. A floating exchange is always desirable by economists apart from post Bretton Woods system. It is supposed to automatically adjust the balance of payment problem and economic changes. However, it is not always desirable. Certain countries prefer to adopt fixed exchange rate due to its certainty over time. It can also be used to control inflation in an economy. The European Exchange Rate Mechanism or ERM deals with the Euro with a fixed currency exchange rate, but the exchange rates are variable within certain margins. It is also referred as Semi-pegged System. The ERM also created a European Currency Unit (ECU), a unit of account. Although it is not a real currency but it became the foundation for the idea of a single currency. In 1990, Great Britain entered in European Exchange rate Mechanism at a rate of 2.95 Deutschmarks to one Pound Sterling. Many critics think that the rate was too high and unrealistic regarding the bands of ERM. However, Britain left the ERM in 1992 because it was becoming impossible to keep the pound within the bands of ERM. That day is still known as the “Black Wednesday” in history. Arguments in Favor of European Monetary System: The single currency concept and the European Monetary System helped the European Economy in improving the overall economic performance. It played a great role in ensuring the stability of the monetary system in the European Community. It would not be easier to achieve the concept of single monetary and economical union in the absence of the ERM. It is very helpful in making political climate better for mutual growth of member countries. As the countries are dependent on each other in financial matters, the attempts of sabotage and cold wars will be eliminated. The facts showed that there is a rapid increase in trade among the member countries than to the non-member countries by European Union. The independence of the central bank helps in making transparent monetary policies and also controls inflation. The prices of goods and services are more transparent than before as there will be no exchange cost and custom duties to pay. Arguments against European Monetary System: A fixed exchange rate is not considered appropriate as per economists because it can be proved dangerous for an economy. Where floating exchange rate is unpredictable and uncertain, fixed exchange rate can mislead the entire economy in a total wrong direction and set in a very adverse situation. The European Monetary system was based on the assumption that one monetary policy will be suitable for all member countries. This assumption is highly unrealistic considering the political situations of each economy and its impacts. The fixed exchange rates are always subject to the Government’s intervention but in European Monetary system this problem is eliminated by the centralization of the central banks of all the member countries. It helps in establishment of a neutral and realistic monetary system. A floating exchange rate will be helpful as an automatic stabilizer for various factors like automatic adjustment of balance of payment, speculation runs from the currency and also several other factors. Such feasibility will not be possible in fixed exchange rate system. In order to have a fixed exchange rate, Governments need a large holding of certain foreign exchange currency reserves to maintain the level of fixed exchange rate. Where a country has fixed exchange rate system, it losses its financial freedom to make its monetary policy. In such case, the economists have to take care of the level of exchange rate before drafting any other policy for inflation or unemployment and in such case many important and more preferable objectives have to be compromised to achieve the desirable level of exchange rate. However in European Union, this issue is addressed by the centralization of the complete monetary system so now the individual governments do not need to worry about loss of freedom over their monetary policy. As their monetary policy is now more integrated and stabilized by mutual growth of other member countries. References: 1. “Krugman, Paul and Maurice Obstfeld.” International Economics: Theory and Policy. 6th ed. 2003. Print. 2. "Robert Mundell." Wikipedia, The Free Encyclopedia. Wikipedia, The Free Encyclopedia, 29 Mar. 2011. Web. 9 Apr. 2011. 3. "Optimum currency area." 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