The UK as a Member of the European Union - Essay Example

Macro and Micro Economics Contents Analysis 3 Key Features of Monetary Union 3 Financial Aid of Monetary Union 4 Foreign Direct Investment Impact 5 Macroeconomic Management 5 Price Transparency 7 Impact on Trade 8 Evaluation 9 Fiscal and Political Changes 9 Currency Depreciation Inability 9 Competitiveness GDP and Employment 11 Constant Interest Rate 11 Economic Management Cost 11 Problems Relating to Fiscal Policies 12 Transition Cost 12 Eurozone Crisis and Benefit of U.K 12 Reference List 14 Analysis Key Features of Monetary Union The European Union (EU) is a group of 28 member states located in Europe. It is a type of monetary and political union. The EU monitors and controls the matters of various institutions such as, the European Central Bank and European Council. After enactment of the Maastricht Treaty in 1992, some member states of EU decided to introduce the new Economic and Monetary Union (EMU) (Minford, 2010). Single currency usage was the primary motto introduced for the Union. All member states of the EMU use a single currency, known as Euro, within their economies. The Union aims to promote stable economic growth for all member states. It also aimed to enhance aggregate employment opportunities in these counties. In order to enhance the level of employability, EMU aims to enhance capital investment levels of its member states. Higher sustainability of pensions and public finances are also achieved in these countries through activities of EMU. The Union tries to improve social status of its member states by increasing the extent of welfare maximizing activities in such markets (Minford, 2010). Figure 1: EMU Members (Source: European Commission, 2012) The above figure shows the member countries of EU, which are also a part of EMU. Financial Aid of Monetary Union EMU provides monetary assistance to its member states at times of emergency or crisis. If a country faces severe credit crunch and is unable to borrow money from the external market at particular rates, then it can avail the financial assistance facility of EMU. The country needs to firstly negotiate its borrowing program with the European Council and International Monetary Fund (Watt, 2014). The programme also needs to be accepted by other member states of the Union. Finally, after considering all legal regulations, the country receives the loan from European Central Bank (ECB). The amount, rates of interest, duration and procurement related activities are managed by European Financial Stability Facility (EFSF) unit (Minford, 2010). Foreign Direct Investment Impact The EMU helps to stimulate economic growth within its member countries. For ensuring this, the Union tries to enhance the level of foreign direct investment (FDI) in these countries. Higher FDI inflow in encouraged by eliminating the transaction cost and lowering risks associated with exchange rate volatilities. Lesser exchange rate volatility helps in stabilizing the prices of goods and services in the market. Moreover, employability in these countries also reflects low fluctuation due to greater stability in wage rates. Transaction costs are the expenses incurred for selling and buying securities in the share market. Such costs are composed of payments of brokers and expenses of spreads. EMU eliminates transaction cost related to security trading within its member states. Thus, speculative investments are less expensive in the EMU countries than other EU nations. Such factors encourage foreign investors to increase the amount of their Greenfield and Portfolio investments in EMU countries (Minford, 2010). Macroeconomic Management From the above context, it can be claimed that the level of exchange rate volatility is low in EMU countries. The overall costs associated with raising capital in these nations are less and the extent of FDI inflow is high. Moreover, elimination of transaction cost and financial stability oriented policies act as macroeconomic management tools of the EMU. By following such practices, EMU aims to lower rate of inflations in economies of the member countries. EMU member countries use a single currency value and hence, levels of speculation maintained are low (Minford, 2010). EMU lowers speculation by making all member states follow the same currency. Lower speculation helps in prohibiting competitive currency depreciation. This in turn lowers interest rates in the markets and augments the level of investments. Higher investments imply greater production and rise in production signifies increase in supply of goods and services. Finally, by increasing aggregate supply within member countries, EMU lowers the rate of inflation (Minford, 2010). Figure 2: Low Inflation in EMU Countries (Source: European Commission, 2012) From the above graph, it can be stated that on an average, inflation rate is maintained around 2% in all EMU countries since 1999. Price Transparency EMU enhances the level of price transparency within member states. Through its macroeconomic management policies, the Union enhances level of market competition within the constituting economies. With the essence of lower interest rates, degree of investments significantly increases in all EMU countries. Higher investments imply larger number of entrants and higher degree of competition in each sector. This enhances supply of goods and services in each economic segment and generates rightward shift of the aggregate supply curve. Given the gross demand curve (AD curve), when aggregate supply curve (AS curve) shifts rightward, average price level in each market appears to decline. Lower average price level implies low inflation and increased competition indicates higher price transparency among EMU economies (Minford, 2010). Figure 3: EMU Price Transparency and Low Inflation Price AD AS AS’ P1 P2 Q1 Q2 Quantity of Demand and Supply (Source: Author’s Creation) Low inflation mechanism encouraged by EMU can be analyzed adequately from the above graph. As the AS curve shifts rightward from AS to AS’ (given the position of AD curve), the gross quantity of supply and demand increase from Q1 to Q2 and the market average price level rises from P1 to P2. Lower price implies lower inflation rate in the market (Besanko and Braeutigam, 2010). Impact on Trade Since inception, EMU significantly enhanced the level of international trade within all its member states. By making member countries adopt a single currency, the commission helped in lowering exchange rate volatilities as well as transaction costs within these economies. This assisted in enhancing the level of international trade in these countries. This instance can be justified through the Gravity Model of International Trade (Federal Reserve Bank, 2000). Hence, it can be claimed that bilateral trade takes place better in countries following similar monetary and fiscal rules (Minford, 2010). Evaluation Fiscal and Political Changes The regulating authority of EMU desires to integrate all member states as “United States of Europe” (Minford, 2010). In order to meet this objective, any new country that attempts to become a member state of the EMU must adopt few fiscal and political changes. The country should have a guaranteed democratic political framework. The constitution of the country should provide adequate attention towards regulations relating to human rights, minorities protection and rule of law. Moreover, fiscally, the country needs to be a market economy and be able to sustain the required level of market competition. All regulations of the EMU should be strictly followed by the country. The HICP inflation rate of the country should not be more than 1.5%. Also, the government budget deficit should not exceed 3% and the debt GDP ratio should be lower than 60% (Folketinget, 2014). The nation’s long-term rate of interest should not be more than 3% and currency value must not depreciate for last two years preceding convergence with EMU (Minford, 2010). Currency Depreciation Inability All member countries of the EMU adhere to a single currency in their economies and maintain equal rate of interest within their money market. The countries within EMU lack power to fluctuate market currency and interest rate when required. Market exuberances in real estate sector had generated the global financial crisis in 2008. The overall level of money supply and rate of investments had fallen in Europe during the recession. U.K. had purposely depreciated domestic currency (pound sterling) by 25% more against the EMU Euro exchange rate (Minford, 2010). Figure 4: Pound Sterling Depreciated during Recession (Source: European Commission, 2012) Currency depreciation enhanced the interest rates in U. K and increased investments within its economy. This is because, foreign investors were attracted to buy into pound sterling in order to reap the benefits of higher interest rates offered by banks of U.K. All such factors enhanced demand for pound in the international exchange markets and in long run, its currency started to appreciate in absence of any other factors. However, member countries of EMU, Greece, Portugal, Ireland and Spain could follow the same strategic policies as U.K., since they operate within a fixed exchange rate regime. During recession, these nations failed to lower currency value and attract more investments (Minford, 2010). Competitiveness GDP and Employment The member countries of EMU could not devaluate exchange rate and encourage higher investments within their economies, during the financial crunch of 2008. As a result, Euro became less attractive in the international speculative market. Recession and low investments seemed to lower aggregate supply of money within EMU countries and in turn reduced gross production capacity. So, low demand had generated lower real GDP in EMU countries during recession. Existing firms within these economies had then reduced their employments for lessening costs. Consequently, fixed exchange rate policy of EMU countries brought down real GDP and employment opportunities within its economies during recession (Minford, 2010). Constant Interest Rate The Monetary Policy Committee of Bank of U.K. can manipulate rate of interest of member economies for establishing the targeted inflation rate. However, the countries of EMU lack such powers. For instance, when interest rate (of lending) is lowered in U.K., individuals of the country get access to more money; hence, are able to enhance their market demand. Higher demand in market enhances the rate of inflation in economy. The concept of “one size fits all” makes ECB fix the interest rates at one level for all EMU countries. This is highly irrational because targeted inflation rates in each economy are different (Minford, 2010). Economic Management Cost After recession in 2008, countries like, Greece, Portugal, Ireland and Italy, had faced severe financial crunches and sought financial assistance from ECB. Financial aids and bail outs had been common in the country since then. It was found that over time, public and private debt burden within these nations had substantially increased. These countries were found to become less productive and had less incentive to revive their economies, given that they faced low degree of financial threats. Economists claim that “Greece knows it is too big to be allowed to fail” (Mkintosh, 2014). ECB requires money to finance productive projects as it must provide higher amount of money to certain underperforming member countries like, Portugal, Greece and Ireland. Thus, economic management for countries is the responsibility of individual countries within the Euro zone (Minford, 2010). Problems Relating to Fiscal Policies The EMU fiscal policies primarily aimed to resolve the external debt sustainability issues. Fiscal measures relating to procyclical factors were not given importance required by EMU (Fatás and Mihov, 2000). The government authorities of EMU countries need to maintain budget deficit below 3% (expenditure–revenue). So, during the financial crunch in 2008, political authorities of the EMU countries failed to undertake required expansionary fiscal policy measures within their economies for avoiding debt rise above 3% (Nobay, 2011). Nevertheless, such factors enhanced the actual external debt demands of these nations. Transition Cost Though transaction costs were lowered in the financial markets of EMU countries, investors were reluctant to invest money therein. This is because; capitalists refused to invest money owing to high debt burdens in these economies. Moreover, small and midsized domestic firms in these countries were not efficient in business due to lack of adequate finances (Nobay, 2011). Eurozone Crisis and Benefit of U.K U.K. is attached with the EU; the country is not a member of the EMU. It uses Pound as a currency, instead of Euro. So, the country is not blessed with the benefits of European Financial Stability Facility (EFSF). Less risk associated with currency fluctuations and elimination of transaction costs encouraged FDI inflow in the EMU nations. Even so, U.K. does not share benefits of the same. In addition, benefits relating to lower inflation rate, greater price transparency and increased foreign trade supported by EMU cannot be experienced by U.K. The country needed to incur several costs in order to become a member of EMU. U.K. could better protect its economy during recession compared to member countries of EMU by following floating exchange rate rules. The real GDP and employability in U.K. has not fallen as that of the EMU countries. This is because, with variable interest rates, the country was able to maintain market rate of inflation and encourage higher investments within its economy. Furthermore, moral hazard issues of Greece and Ireland had not affected U.K.’s economy. From the above analysis, it can be claimed that costs associated with EMU membership outweigh corresponding benefits. Therefore, it is highly rational for U.K. to have become a member of Eurozone, without having Euro as currency (European Commission, 2005). Reference List Besanko, D. and Braeutigam, R., 2010 Microeconomics. New York City: John Wiley & Sons. European Commission, 2005. Directorate general for economic and financial affairs. [pdf] EC. Available at: [Accessed 2 June 2014]. European Commission, 2012. The economic and monetary union and the euro. [pdf] EC. Available at: [Accessed 2 June 2014]. Fatás, A. and Mihov, I., 2000. Fiscal discipline, volatility and growth. [pdf] Wordpress. Available at: [Accessed 2 June 2014]. Federal Reserve Bank, 2000. Do currency unions increase trade? a "gravity" approach. [online] Available at: [Accessed 2 June 2014]. Folketinget, 2014. What requirements must countries meet to become members of the EU? [online] Available at: [Accessed 2 June 2014]. Minford, P., 2010. The costs and benefits of Economic and Monetary Union to the UK economy. [pdf] Cardiff University. Available at: http://www.euro-know.org/europages/bforsEMUTEST5r8.pdf [Accessed 2 June 2014]. Mkintosh, J., 2014. Moral hazard saving Greece again. Financial Times, 21 February. Nobay, A. R., 2011. The political economy of EMU. [pdf] FMG. Available at: [Accessed 2 June 2014]. Watt, N., 2014.Eurozone countries should form United States of Europe, says EC vice-president. The guardian, 17 February. Read More