The Eurozone: one currency and one interest rate

Overview

Country actually surrender, single currency increase competition through price transparency and asymmetric shock.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What does a country actually surrender, and what does it acquire, when it adopts a single currency?

   Model answer

   It surrenders its national currency at an irrevocably fixed conversion rate, and with it the ability to set its own interest rate and to let its exchange rate against other members move. Monetary policy passes to a common central bank that sets one policy rate for the whole area and manages the single currency, and the national central bank becomes an operating arm of that system rather than an independent authority. In return the country acquires a currency used across the whole area, so exchange rate risk and conversion cost within it disappear, and it acquires the credibility of the common central bank's commitment to price stability.

2. 2

   A firm buys and sells 40 million euros' worth of goods a year across borders within a currency area and previously faced conversion costs averaging 0.5% of the value converted. Calculate its annual saving from the single currency and explain why the true gain is larger than that figure.

   Model answer

   The saving on conversion is 0.5% of €40 million, which is €200,000 a year. The true gain is larger because the conversion charge is only the visible cost. The firm also had to bear the risk that the exchange rate moved between agreeing a price and being paid, and either accepted that risk or paid to hedge it, and it had to run treasury systems to manage several currencies. Removing the currency also removes those risk and administration costs, and it removes the uncertainty that deterred some cross-border contracts altogether, so trade volumes rise as well as costs falling.

3. 3

   How does a single currency increase competition through price transparency?

   Model answer

   When prices in different member states are quoted in different currencies, comparing them requires a conversion and an allowance for the risk that the rate will move, so consumers and business buyers compare imperfectly and firms can sustain different prices for the same good in different national markets. A single currency puts every price in the same units, so the comparison is immediate. Buyers switch to the cheapest source, arbitrage narrows the gaps, and firms lose the ability to segment the area into separate national markets. The result is prices closer to costs and a squeeze on margins in previously sheltered markets.

4. 4

   Explain the chain by which exchange rate certainty inside a currency area raises trade and investment.

   Model answer

   With separate currencies, a firm signing a cross-border contract does not know what the receipt will be worth in its own currency when payment arrives, so the expected return is uncertain and the firm requires a higher expected margin, hedges at a cost, or does not trade at all. Removing the currency removes that risk entirely for trade within the area. The required return on cross-border projects falls, so more contracts and more investment projects clear the hurdle; supply chains can be organised on the basis of cost rather than currency exposure; and firms can commit to long-lived plant in another member state without a currency risk that lasts the life of the asset. Trade and cross-border investment within the area therefore rise.

5. 5

   Why can a country with a history of high inflation obtain lower borrowing costs by joining a currency union?

   Model answer

   Lenders demand compensation for expected inflation and for the risk that a government will allow inflation or a depreciation to erode the real value of its debt, so a country with a poor inflation record pays a premium in its interest rates. Joining a currency union transfers monetary policy to a central bank with an established commitment to price stability and removes the possibility of a national devaluation, so expected inflation and currency risk fall. Nominal and real interest rates fall accordingly, which lowers the cost of servicing debt and the cost of capital for firms. The danger is that cheap credit then fuels a borrowing and asset-price boom that the country can no longer restrain with its own interest rate.

6. 6

   Analyse why a single interest rate for a whole currency area creates difficulties when member economies are at different points in their cycles.

   Model answer

   The common rate is set for conditions in the area as a whole, so it is effectively an average. A member growing above trend with rising inflation needs a rate above the average to restrain demand, but receives the average, so its real interest rate is too low, credit and asset prices expand and it overheats. A member in recession with inflation below the average needs a rate below it, but again receives the average, so its real interest rate is too high and the downturn deepens. Because the real rate is the nominal rate minus each member's own inflation, the single nominal rate is automatically most stimulative where inflation is highest and most restrictive where it is lowest, which pushes members further apart rather than bringing them together.

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