Chapter 20: Optimum Currency Areas and the European Experience Multiple Choice Questions 1.

What are the biggest advantages the U.S. has above the EU in terms of being an Optimum Currency Area? A. Lo mobi!ity of !abor" higher !abor productivity" !o er !eve! of intra#regiona! trade $. %igh unioni&ation of U.S. Labor force C. ' don(t )no . *. %igh mobi!ity of !abor force" more transfer payments bet een regions E. %igher uniformity of popu!ation(s taste in consumption Ans er+ * ,. -he European .onetary System A. caused severa! countries to go into recession by causing interest rates to rise. $. pegged different European currencies to each other" a!!o ing for bands of variance. C. as a product of the Werner /eport. *. fe!! apart in 1012. E. 3one of the above. Ans er+ A 4. -he credibi!ity theory of the E.S states that countries avoid A. short#term interest rate changes to avoid !ong#term inf!ation. $. depreciating their currencies to avoid po!itica! instabi!ity. C. short#term gains from depreciation to avoid !ong#term costs from inf!ation. *. short#terms economic booms. Ans er+ C 5. -he European Economic and .onetary Union A. set up a sing!e currency and so!e ban) for European economic monetary po!icy. $. e!iminated a!! barriers to trade such as ta6 differentia!s bet een borders. C. produced a sing!e government for hand!ing European affairs. *. created the Common Agricu!tura! 7act . E. 3one of the above. Ans er+ A

81

9.

-he birth of the Euro A. resu!ted in fi6ed e6change rates bet een a!! E.U member countries. $. resu!ted in f!e6ib!e e6change rates bet een a!! E.U member countries. C. resu!ted in cra !ing#peg e6change rates bet een a!! E.U member countries. *. resu!ted in non#currency board e6change rates bet een a!! E.U member countries. E. 3one of the above. Ans er+ A

8.

Which of the fo!!o ing is true? A. A!! European countries are part of the E.U. $. A!! Western European countries are part of the E.U. C. Origina!!y" 11 countries :oined the E.Uin ;anuary 1000. *. 3ot a!! Western European countries are part of the E.U. E. 3one of the above. Ans er+ C

2.

-he E.U created a currency area ith more than A. ,<< mi!!ion consumers. $. ,9< mi!!ion consumers. C. about a bi!!ion customers. *. 9<< mi!!ion consumers. E. 4<< mi!!ion consumers. Ans er+ E

1.

-he EU countries ere prompted to see) c!oser coordination of monetary po!icies and greater e6change rate stabi!ity in the !ate 108<s in order A. to enhance Europe(s ro!e in the or!d monetary system. $. to turn the European Union into a tru!y unified mar)et. C. both to enhance Europe(s ro!e in the or!d monetary system and to turn the European Union into a tru!y unified mar)et. *. 3one of the above. E. both to turn the European Union into a tru!y unified mar)et and to counter the rise of ;apan in internationa! financia! mar)ets. Ans er+ C

80

0.

Which of the fo!!o ing statements is true? A. -he 1092 -reaty of /ome founded the EU and created a custom union. $. -he 1092 -reaty of /ome founded the EU. C. -he 1092 -reaty of /ome founded the euro. *. -he 1092 -reaty of /ome founded the European Centra! $an). E. -he 1092 -reaty of /ome founded the Stabi!ity and =ro th 7act.)no n as S=7. Ans er+ A

1<.

-he fo!!o ing countries consistent!y participated in the informa! :oint f!oat against the do!!ar" )no n as the >sna)e"? in 1021#1024+ A. =ermany" @rance" the 3ether!ands" $e!gium and Lu6embourg. $. =ermany" 'ta!y" the 3ether!ands" $e!gium and Lu6embourg. C. =ermany" the United Aingdom" @rance" the 3ether!ands" $e!gium and Lu6embourg. *. =ermany" the 3ether!ands" $e!gium and Lu6embourg. E. =ermany" @rance" 'ta!y" the 3ether!ands" $e!gium and Lu6embourg. Ans er+ *

11.

-he European .onetary System as founded on the initiative of A. @rance and =ermany. $. @rance" =ermany" and $e!gium. C. @rance" =ermany" $e!gium" and Lu6emburg. *. @rance" =ermany" $e!gium" Lu6emburg" and the 3ether!ands. E. @rance" =ermany" $e!gium" Lu6emburg" the 3ether!ands" and Austria. Ans er+ A

1,.

-he credibi!ity theory of the E.S imp!ies in effect that the po!itica! costs of vio!ating internationa! e6change rate agreements A. cannot restrain governments from depreciating their currency. $. can restrain governments from depreciating their currency. C. cannot restrain governments from depreciating their currency in the short run. *. cannot restrain governments from depreciating their currency in the !ong run. E. 3one of the above. Ans er+ $

2<

14.

-he credibi!ity theory of the E.S imp!ies in effect that the po!itica! costs of vio!ating internationa! e6change rate agreements A. cannot restrain governments from depreciating their currency to gain the short#term advantage of an economic boom at the !ong#term cost of higher inf!ation. $. can restrain governments from depreciating their currency to gain the short# term advantage of an economic boom at the !ong#term cost of higher inf!ation. C. cannot restrain governments from depreciating their currency in the short run. *. cannot restrain governments from depreciating their currency in the !ong run. E. 3one of the above. Ans er+ $

15.

-he credibi!ity theory of the E.S imp!ies in effect that the po!itica! costs of vio!ating internationa! e6change rate agreements A. cannot restrain governments from depreciating their currency to gain the short#term advantage of an economic boom at the !ong#term cost of higher inf!ation.. $. can restrain governments from depreciating their currency to gain the !ong# term advantage of an economic boom at the short#term cost of higher inf!ation. C. can restrain governments from depreciating their currency to gain the short# term advantage of an economic boom at the !ong#term cost of higher inf!ation. *. cannot restrain governments from depreciating their currency in the short run. E. 3one of the above. Ans er+ C

19.

Centra! ban) independence appears to be associated ith A. high inf!ation. $. !o unemp!oyment. C. !o inf!ation. *. high unemp!oyment. E. high government deficit. Ans er+ C

21

18.

Which one of the fo!!o ing statements is true? A. -o )eep its reputation as a fighter against inf!ation" the =erman centra! ban) has never intervened in E.S currency. $. -o )eep its reputation as a fighter against inf!ation" the =erman centra! ban) has often intervened in E.S currency. C. -he =erman centra! ban) carried out some interventions in E.S currencies" thus reducing the supp!y of *.. *. -he =erman centra! ban) carried out some interventions in E.S currencies" but it instant!y steri!i&ed any domestic effects. E. 3one of the above. Ans er+ *

12.

-he po!icies of the =erman centra! ban) resu!ted in a system that functioned in the A. asymmetric ay the $retton Woods system did under U.S. dominance. $. symmetric ay the $retton Woods system did under U.S. dominance. C. symmetric ay the $retton Woods system did under U.A. dominance. *. asymmetric ay the $retton Woods system did under U.A. dominance. E. 3one of the above. Ans er+ A

11.

Under the E.S" =ermany set the system(s A. monetary po!icy hi!e the other European countries pegged their currencies to the *.. $. fisca! po!icy hi!e the other European countries pegged their currencies to the *.. C. monetary po!icy hi!e the other European countries )ept their currencies f!uctuating re!ative to the *.. *. fisca! po!icy hi!e the other European countries pegged their currencies to the *.. E. 3one of the above. Ans er+ A

2,

10.

An inf!ation#prone country A. gains from vesting its monetary po!icy decisions ith a >conservative? centra! ban). $. !oses from vesting its monetary po!icy decisions ith a >conservative? centra! ban). C. gains from vesting its fisca! po!icy decisions ith a >conservative? centra! ban). *. !oses from vesting its fisca! po!icy decisions ith a >conservative? centra! ban). E. 3one of the above. Ans er+ A

,<.

-he most important feature of the Sing!e European Act of 1018" hich amended the founding -reaty of /ome" as dropping the reBuirement of A. unanimous consent for measures re!ated to mar)et comp!etion and ma)ing it a decision that on!y =ermany and @rance agreed about. $. unanimous consent for measures re!ated to mar)et comp!etion. C. ma:ority consent for measures re!ated to mar)et comp!etion and ma)ing it a decision that on!y =ermany and @rance agreed about. *. unanimous consent for measures re!ated to agricu!tura! po!icies on!y. E. unanimous consent for measures re!ated on!y to fisca! po!icies. Ans er+ $

,1.

-o :oin the E.U" a country shou!d have no more than a A. 1.9 percent inf!ation rate above the average of the three EU member states ith the highest inf!ation. $. 4 percent inf!ation rate above the average of the three EU member states ith the lowest inf!ation. C. 5 percent inf!ation rate above the average of the three EU member states ith the lowest inf!ation. *. 1.9 percent inf!ation rate above the average of the three EU member states ith the lowest inf!ation. E. 3one of the above. Ans er+ *

,,.

-o :oin the E.U" a country must have A. a pub!ic#sector deficit no higher than 4 percent of its =*7 in genera!. $. a pub!ic#sector deficit no higher than , percent of its =*7 in genera!. C. a pub!ic#sector deficit no higher than 1 percent of its =*7 in genera!. *. a &ero pub!ic#sector deficit. E. 3one of the above. Ans er+ A

24

,4.

-o :oin the E.U" a country must have a pub!ic debt be!o or approaching a reference !eve! of A. 9< percent of its =*7. $. 1< percent of its =*7. C. 8< percent of its =*7. *. 1<< percent of its =*7. E. 9 percent of its =*7. Ans er+ C

,5.

A ma:or economic A. benefit of fi6ed e6change rates it that they simp!ify economic ca!cu!ations and provide a more predictab!e basis for decisions that invo!ve internationa! transactions than do f!oating rates.. $. benefit of f!oating e6change rates it that they simp!ify economic ca!cu!ations and provide a more predictab!e basis for decisions that invo!ve internationa! transactions than do fi6ed rates. C. cost of fi6ed e6change rates it that they simp!ify economic ca!cu!ations and provide a more predictab!e basis for decisions that invo!ve internationa! transactions than do currency board rates. *. benefit of f!e6ib!e e6change rates it that they simp!ify economic ca!cu!ations and provide a more predictab!e basis for decisions that invo!ve internationa! transactions than do cra !ing peg rates. E. 3one of the above. Ans er+ A

,9.

-he efficiency A. gain from a fi6ed e6change rate ith the euro is sma!!er hen trade bet een say" 3or ay and the euro &one" is e6tensive than hen it is sma!!. $. gain from a fi6ed e6change rate ith euro is greater hen trade bet een say" 3or ay and the euro &one" is e6tensive than hen it is sma!!. C. !oss from a fi6ed e6change rate ith the euro is sma!!er hen trade bet een say" 3or ay and the euro &one" is e6tensive than hen it is sma!!. *. gain from a fi6ed e6change rate ith euro is the same as hen trade bet een say" 3or ay and the euro &one" is e6tensive than hen it is sma!!. E. gain from a fi6ed e6change rate ith euro is the same as hen trade bet een say" 3or ay and the euro &one" is sma!! than hen it is sma!!. Ans er+ $

25

,8.

-he monetary efficiency A. !oss from pegging the 3or egian )rone to the euro Cfor e6amp!eD i!! be higher if factors of production can migrate free!y bet een 3or ay and the euro area. $. gain from pegging the 3or egian )rone to the euro Cfor e6amp!eD i!! be !o er if factors of production can migrate free!y bet een 3or ay and the euro area. C. gain from pegging the 3or egian )rone to the euro Cfor e6amp!eD i!! be higher if factors of production cannot migrate free!y bet een 3or ay and the euro area. *. gain from pegging the 3or egian )rone to the euro Cfor e6amp!eD i!! be higher if factors of production can migrate free!y bet een 3or ay and the euro area. E. %ard to te!!. Ans er+ *

,2.

Which one of the fo!!o ing statements is true? A. -he !ess e6tensive are cross#border trade and factor movements" the greater is the gain from a fi6ed cross#border e6change rate. $. -he more e6tensive are cross#border trade and factor movements" the greater is the !oss from a fi6ed cross#border e6change rate. C. -he more e6tensive are cross#border trade and factor movements" the greater is the gain from a fi6ed cross#border e6change rate. *. -he more e6tensive are cross#border trade" the greater is the !oss from a fi6ed cross#border e6change rate. E. -he more e6tensive are factor movements" the greater is the !oss from a fi6ed cross#border e6change rate. Ans er+ C

,1.

Which one of the fo!!o ing statements is true? 7ic) on!y one ans er. A. -he !arger e6change rate area has a more stab!e and predictab!e price !eve! than the country that :oins in. $. -he sma!!er e6change rate area has a more stab!e and predictab!e price !eve! than the country that :oins in. C. -he !arger e6change rate area has a more predictab!e price !eve! than the country that :oins in. *. -he sma!!er e6change rate area has a more stab!e and predictab!e price !eve! than the country that :oins in. E. A!! of the above are possib!e a!ternatives. Ans er+ E

29

,0.

Which one of the fo!!o ing statements is true? 7ic) on!y one ans er. A. -he !arger e6change rate area has more commitment to fi6ed e6change rate than one country that tries to :oin in. $. -he !arger e6change rate area has !ess commitment to fi6ed e6change rate than one country that tries to :oin in. C. -he !arger e6change rate area has more commitment to fi6ed e6change rate than t o countries that try to :oin in together. *. -he !arger e6change rate area has !ess commitment to fi6ed e6change rate than t o countries that tries to :oin in together. E. A!! of the above are possib!e a!ternatives. Ans er+ E

4<.

A country that :oins an e6change rate area A. gives up its abi!ity to use the e6change rate for the purpose of stabi!i&ing output and emp!oyment. $. does not give up its abi!ity to use the e6change rate and monetary po!icy for the purpose of stabi!i&ing output and emp!oyment. C. gives up its abi!ity to use the e6change rate and monetary po!icy for the purpose of stabi!i&ing output and emp!oyment. *. gives up its abi!ity to use on!y monetary po!icy for the purpose of stabi!i&ing output and emp!oyment. E. gives up its abi!ity to use on!y monetary po!icy for the purpose of stabi!i&ing output and emp!oyment. Ans er+ C

41.

When the economy is disturbed by a change in the output mar)et" A. a fi6ed e6change rate has an advantage over a f!e6ib!e rate. $. a f!oating e6change rate has an advantage over a fi6ed rate. C. a cra !ing peg e6change rate has an advantage over a fi6ed rate. *. a f!oating e6change rate has the same effect as a fi6ed rate. E. 3one of the above. Ans er+ $

28

4,.

Which one of the fo!!o ing statements is true? A. A fi6ed e6change rate automatica!!y cushions the economy(s output and emp!oyment by a!!o ing an immediate change in the relative price of domestic and foreign goods. $. A f!e6ib!e e6change rate does not automatica!!y cushion the economy(s output and emp!oyment by a!!o ing an immediate change in the relative price of domestic and foreign goods. C. A f!e6ib!e e6change rate automatica!!y cushions the economy(s output and emp!oyment by a!!o ing an immediate change in the relative price of domestic and foreign goods. *. A f!e6ib!e e6change rate automatica!!y cushions the economy(s output and emp!oyment by a!!o ing an immediate change in the absolute price of domestic and foreign goods E. 3one of the above. Ans er+ C

44.

When the e6change rate is A. f!e6ib!e" purposefu! stabi!i&ation is more difficu!t because monetary po!icy has no po er at a!! to affect domestic output and emp!oyment. $. fi6ed" purposefu! stabi!i&ation is !ess difficu!t because monetary po!icy has no po er at a!! to affect domestic output and emp!oyment. C. fi6ed" purposefu! stabi!i&ation is more difficu!t because monetary po!icy has no po er at a!! to affect domestic output and emp!oyment. *. a cra !ing peg" rather than fi6ed" purposefu! stabi!i&ation is more difficu!t because monetary po!icy has no po er at a!! to affect domestic output and emp!oyment. E. fi6ed rather than cra !ing peg" purposefu! stabi!i&ation is more difficu!t because fisca! po!icy has no po er at a!! to affect domestic output and emp!oyment. Ans er+ C

45.

When 3or ay uni!atera!!y fi6es its e6change rate against the euro but !eaves the )rone A. free to f!oat against the non#euro currencies" it is able to )eep at least some monetary independence. $. free to f!oat against the non#euro currencies" it is unable to )eep at least some monetary independence. C. free to f!oat against the non#euro currencies" it is able to )eep its monetary independence. *. run by cra !ing peg against the non#euro currencies" it is able to )eep at !east some monetary independence. E. 3one of the above. Ans er+ $

22

49.

After 3or ay uni!atera!!y pegs the )rone to the euro" domestic money mar)et disturbances i!! A. no longer affect domestic output despite the continuation of f!oat#rate regime against non#euro currencies. $. now have a major effect on domestic output despite the continuation of f!oat# rate regime against non#euro currencies. C. have some effect on domestic output despite the continuation of f!oat#rate regime against non#euro currencies. *. Have a major effect on domestic emp!oyment despite the continuation of f!oat#rate regime against non#euro currencies. E. 3one of the above. Ans er+ A

48.

A )roneEeuro peg a!one is A. not enough to provide automatic stabi!ity in the face of any monetary shoc)s that shift the AA schedu!e. $. enough to provide automatic stabi!ity in the face of any monetary shoc)s that shift the AA schedu!e. C. not enough to provide automatic stabi!ity in the face of any monetary shoc)s that shift the AA schedu!e" provided fisca! po!icy i!! be used as e!!. *. enough to provide automatic stabi!ity in the face of any monetary shoc)s that shift the AA schedu!e" provided the government runs a budget deficit. E. 3one of the above. Ans er+ $

42.

Since 3or ay has c!ose trading !in)s ith the euro &one" A. a sma!! reduction in its price i!! !ead to an increase in euro &one demand for 3or egian goods that is large re!ative to 3or ay(s output. -hus" fu!! emp!oyment can be restored fair!y Buic)!y. $. a small reduction in its price i!! !ead to a decrease in euro &one demand for 3or egian goods that is large re!ative to 3or ay(s output. -hus" fu!! emp!oyment can be restored fair!y Buic)!y. C. a small reduction in its price i!! !ead to an increase in euro &one demand for 3or egian goods that is small re!ative to 3or ay(s output. -hus" fu!! emp!oyment can be restored fair!y Buic)!y. *. a big reduction in its price i!! !ead to an increase in euro &one demand for 3or egian goods that is large re!ative to 3or ay(s output. -hus" fu!! emp!oyment can be restored fair!y Buic)!y. E. 3one of the above. Ans er+ A

21

41.

'f 3or ay(s !abor and capita! mar)ets are high!y corre!ated ith those of its euro &one neighbors" A. unemp!oyed or)ers can easi!y move abroad to find or)" and domestic capita! can be shifted to more profitab!e uses in other countries. $. unemp!oyed or)ers cannot easi!y move abroad to find or)" and domestic capita! cannot be shifted to more profitab!e uses in other countries. C. hi!e unemp!oyed or)ers can easi!y move abroad to find or)" domestic capita! cannot be shifted to more profitab!e uses in other countries. *. hi!e capita! can easi!y move abroad to be put to a more profitab!e use" unemp!oyed or)ers cannot easi!y move abroad to find or). E. 3one of the above. Ans er+ A

40.

-he abi!ity of factors to migrate abroad A. reduces the severity of unemp!oyment and the fa!! in the rate of return avai!ab!e to investors. $. increases the severity of unemp!oyment and the fa!! in the rate of return avai!ab!e to investors. C. reduces the severity of unemp!oyment but increases the fa!! in the rate of return avai!ab!e to investors. *. cannot change the severity of unemp!oyment and the constant rate of return avai!ab!e to investors. E. 3one of the above. Ans er+ A

5<.

Which one of the fo!!o ing statements is true for 3or ay" a non#euro country? A. Of course" o ners of capita! that cannot be moved cannot avoid more of the economic stabi!ity !oss due to fi6ed e6change rates hen 3or ay(s economy is open to capita! f!o s. $. Even o ners of capita! that cannot be moved can avoid more of the economic stabi!ity !oss due to fi6ed e6change rates hen 3or ay(s economy is open to capita! f!o s. C. O ners of capita! that cannot be moved can avoid more of the economic stabi!ity !oss due to fi6ed e6change rates hen 3or ay(s economy is closed to capita! f!o s. *. Even o ners of capita! that can be moved can avoid more of the economic stabi!ity !oss due to fi6ed e6change rates hen 3or ay(s economy is closed to capita! f!o s. E. 3one of the above. Ans er+ $

20

51.

-he intersection of == and LL determines A. the optima! !eve! of integration desired by 3or ay. $. the ma6imum integration !eve! desired by 3or ay. C. the minimum !eve! of integration that i!! cause 3or ay to :oin the fi6ed e6change rate regime. *. the ma6imum !eve! of integration that i!! cause 3or ay to :oin the fi6ed e6change rare regime. E. 3one of the above. Ans er+ C

5,.

-he European Centra! $an) has its headBuarter in A. London. $. $er!in. C. @ran)furt. *. 7aris. E. $russe!s. Ans er+ C

54.

-he !eve! of fisca! federa!ism in the European Union is A. too big to cushion member countries from adverse economic events. $. too sma!! to cushion member countries from adverse economic events. C. appropriate to cushion member countries from adverse economic events. *. too big re!ative to the one in the U.S. E. simi!ar in its !eve! to that of the U.S. Ans er+ $

1<

Essay Questions 1. %o and hy did Europe set up its sing!e currency?

Ans er+ -he hy part of the Buestion is re!ated to !arge f!uctuations in the e6change rates among the European countries disturbed trade. A!so" one of the main reasons as to design a ay to prevent future or!d ar. -he ho part of the Buestion is re!ated to the co!!apse of $reton oods and the European Currency reform of 1080#1021. -he Werner /eport of 1021 estab!ished a three#phase program to !ead to the E.U. ,. %o did the European sing!e currency evo!ve?

Ans er+ -he ans er is re!ated to the co!!apse of $retton Woods and the European Currency reform of 1080#1021. -he Werner /eport of 1021estab!ished a three#phase program to !ead to the E.U. 4. What prompted the EU countries to see) c!oser coordination of monetary po!icies and greater e6change rate stabi!ity in the !ate 108<s? 1. ,. -o enhance Europe(s ro!e in the or!d monetary system. -o turn the European Union into a tru!y unified mar)et.

Ans er+ 5.

*iscuss the effects of the reunification of eastern and estern =ermany in 100< on both =ermany and its neighboring European countries.

Ans er+ =ermany+ boom" high interest rates to fight inf!ation. Other European countries+ @rance" 'ta!y and UA in recession" trying to match the high =erman interest rates to ho!d their currencies fi6ed against =ermany(s" thereby pushing their economies into deep recession. Other European countries tried to continue the fi6ed e6change rate in order not to !ose the credibi!ity they had bui!t up since 1019. -he po!icy conf!ict bet een =ermany and the other European countries !ed to a series of fierce specu!ative attac)s on the E.S e6change parities starting in September 100,. $y August 1004" the E.S as forced to retreat to very ide CF# 1< percentD bands" hich as )ept in force unti! the introduction of the euro in 1004. 9. E6p!ain hy the E.S countries decided to fi6 their e6change rates against the =erman *.?

Ans er+ 'n this ay" the other E.S countries in effect imported the credibi!ity of the =erman centra! ban) in fighting inf!ation" thus discouraging the deve!opment of inf!ationary pressures at home.

11

8.

E6p!ain the credibi!ity theory of the E.S.

Ans er+ 'n this ay" the other E.S countries in effect imported the credibi!ity of the =erman centra! ban) in fighting inf!ation" thus discouraging the deve!opment of inf!ationary pressures at home. -his is )no n as the credibi!ity theory of the E.S. 2. E6p!ain ho the =erman $undesban) gained its !o #inf!ation reputation.

Ans er+ .ain!y" =ermany(s e6perience ith hyperinf!ation in the 10,<s and again after Wor!d War '' !eft the =erman e!ectorate ith a deep!y rooted fear of inf!ation. -he !a estab!ishing the $undesban) sing!ed out the defense of the *.(s rea! va!ue as the primary goa! of the =erman centra! ban). 1. *escribe the main provisions of the .aastricht -reaty of 1001.

Ans er+ pages 81,#814. 't ca!!ed for a sing!e currency by ;anuary 1" 1000" harmoni&ing socia! security po!icy ithin the European Union" and centra!i&ing foreign and defense po!icy decisions. 0. Why did the EU countries move a ay from the E.S to ard the goa! of a sing!e shared currency? -o produce a greater degree of European mar)et integration by removing the threat of E.S currency rea!ignments. -o reduce =erman dominance of the E.S monetary po!icy. =iven the move to comp!ete freedom of capita! movements ithin the EU" fi6ed but ad:ustab!e currency parities" may !ead to ferocious!y specu!ative attac)s" as in 100, G 1004. -o guarantee the political stabi!ity of Europe.

Ans er+ 1. ,. 4. 5. 1<.

%o ere the initia! members of E.U chosen? %o i!! ne members be admitted? What is the structure of the comp!e6 of financia! and po!itica! institutions that govern economic po!icy in the euro &one?

Ans er+ EU countries shou!d satisfy+ 1. Lo inf!ation rate Cno more than 1.9 percent above the average of the three EU member states ith the lowest inf!ationD. ,. A stab!e e6change rate ithin the E/.. 4. 7ub!ic#sector deficit no higher than 4 percent of its =*7 in genera!. 5. A pub!ic debt be!o or approaching a reference !eve! of 8< percent of its =*7.

1,

11.

E6p!ain the difficu!ties in naming the ne European currency.

Ans er+ pages 818#812. Among the reasons+ )eeping the name ECU ou!d be mis!eadingH the ECU depreciated sharp!y against the *.H the Euro had ba d conotaitons for =ermans and =ree)sH and names such as fran)en and shi!!ings raise ob:ections as e!!. 1,. >-he costs and benefits for a country from :oining a fi6ed#e6change rate area such as the E.S depend on ho e!!#integrated its economy is ith those of its potentia! partners.? *iscuss.

Ans er+ 'n genera!" true. -his is the theory of optimum currency area. .unde!! as a arded the 3obe! 7ri&e for deve!oping the theory. 14. *iscuss the benefits and costs of :oining a fi6ed#e6change area.

Ans er+ $enefits+ in genera!" gains from the stabi!ity of the area and reduced uncertainty. -he efficiency gain from a fi6ed e6change rate ith the euro is greater hen trade bet een" say 3or ay and the euro &one" is e6tensive than hen it is sma!!. A ma:or economic benefit of fi6ed e6change rates it that they simp!ify economic ca!cu!ations and provide a more predictab!e basis for decisions that invo!ve internationa! transactions than do f!oating rates. -he monetary efficiency gain from pegging" say the 3or egian )rone to the euro" i!! be higher if factors of production can migrate free!y bet een 3or ay and the euro area. -he more e6tensive are cross#border trade and factor movements" the greater is the gain from a fi6ed cross#border e6change rate Costs+ A country that :oins an e6change rate area gives up its abi!ity to use the e6change rate and monetary po!icy for the purpose of stabi!i&ing output and emp!oyment. When the economy is disturbed by a change in the output mar)et" a f!oating e6change rate has an advantage over a fi6ed rate. A f!e6ib!e e6change rate automatica!!y cushions the economy(s output and emp!oyment by a!!o ing an immediate change in the relative price of domestic and foreign goods. When the e6change rate is fi6ed" purposefu! stabi!i&ation is more difficu!t because monetary po!icy has no po er at a!! to affect domestic output and emp!oyment 15. E6p!ain hy hen 3or ay uni!atera!!y fi6es its e6change rate against the euro but !eaves the )rone free to f!oat against the non#euro currencies" it is unable to )eep at least some monetary independence.

Ans er+ Any independent money supp!y change in 3or ay ou!d put pressure on )rone interest rates and thus on the )roneEeuro e6change rate. So by pegging the )rone even to a sing!e foreign currency" 3or ay comp!ete!y surrenders its domestic monetary contro!.

14

19.

E6p!ain hy after" say 3or ay uni!atera!!y pegs the )rone to the euro" domestic money mar)et disturbances i!! no longer affect domestic output despite the continuation of f!oat#rate regime against non#euro currencies.

Ans er+ $ecause 3or ay(s interest rate must eBua! the euro interest rate" any pure shifts in the AA curve Csee Chapter 10D i!! resu!t in immediate reserve inf!o s or outf!o s that !eave 3or ay(s interest rate unchanged. 18. E6p!ain hy even o ners of capita! that cannot be moved can avoid more of the economic stabi!ity !oss due to fi6ed e6change rates hen 3or ay(s economy is open to capita! f!o s.

Ans er+ -he main reason is through diversification. 'f 3or ay(s capita! mar)et is integrated ith those of the E.U neighbors" 3or egians i!! invest some of their ea!th in other countries hi!e at the same time part of 3or ay(s capita! stoc) i!! be o ned by foreigners. 12. E6p!ain hy the oi! price shoc)s after 1024 made countries un i!!ing to revive the $retton Woods system of fi6ed e6change rates.

Ans er+ Using the == G LL frame or) i!! he!p so!ve this Buestion. -he oi! price shoc) of 1024 pushes the LL curve up ard and to the right. -hus" the !eve! of economic integration at hich it becomes orth hi!e to :oin the currency rises. 'n genera!" increased variabi!ity in the product mar)ets ma)es countries !ess i!!ing to enter fi6ed e6change rate areas. -his prediction he!ps e6p!ain hy the oi! price shoc)s after 1024 made countries un i!!ing to revive the $retton Woods system of fi6ed e6change rates. 11. E6p!ain hy it may ma)e sense for the United States" ;apan" and Europe to a!!o their mutua! e6change rate to f!oat?

Ans er+ Even though these regions trade ith each other" the e6tent of that trade is modest compared ith regiona! =37s" and interregiona! !abor mobi!ity is !o . 10. 's Europe an optimum currency area?

Ans er+ An open Buestion. ' thin) yes" the area(s economy is c!ose!y integrated ith its o n+ most EU members e6port from 1< to ,< percent of their output to other EU members. $ut sti!!" the !a of one price does not app!y to many products such as the auto mar)et. 'n 1001" prices for the $.W 9,<i varied by as much as ,0.9 percent bet een the United Aingdom and the 3ether!ands. 7rices for the @ord @iesta varied as much as 54.9 percent bet een the United Aingdom and 7ortuga!I -he te6t is more critica!" c!aiming on page 8,9+ >-he e6tent of intra#European trade is not !arge enough" ho ever" to give us an over he!ming reason for be!ieving the European Union itse!f is an optimum currency area.? A!so" the te6t cites the fact that may be price convergence has more to do ith 'nternet mar)eting than optimum currency area.

15

-he boo) conc!udes that on ba!ance" it seems doubtfu! that the 100, measures have yet pushed Europe dramatica!!y c!oser to being an optimum currency area. See a!so pages 8,9 G 8,8" and even pages 8,9 # 84<. ,<. %o mobi!e is Europe(s !abor force?

Ans er+ *ifferences in !anguage and cu!ture discourage !abor movements bet een European countries. *ifferences in regiona! unemp!oyment rates are sma!!er and !ess persistent in the United States than are differences bet een nationa! unemp!oyment rates in the European Union. Even within European countries" !abor mobi!ity appears !imited" part!y because of government regu!ations. @or e6amp!e" the reBuirement in some countries that or)ers estab!ish residence before receiving unemp!oyment benefits ma)es it harder for unemp!oyed or)ers to see) :obs in regions that are far from their current homes. ,1. %o much trade do currency unions create?

Ans er+ -he main resu!t is that currency unions promote trade. One study found that on average" t o countries that are members of the same currency union trade three times as much ith each other as countries that do not share a currency. Even if the euro ere to raise trade ithin the euro &one by 9< percent" the positive effect on peop!e(s e!fare cou!d be immense" as another study has sho n. %o ever" some cha!!enge the conc!usion. Some c!aim the resu!ts ou!d not be dup!icated hen app!ied to !arge countries such as the members of the EUH another study found out that !eaving a common currency area as 're!and did has not caused a reduction in UA # 're!and trade. ,,. E6p!ain hy the European Union(s current combination of rapid capita! migration ith !imited !abor migration may actua!!y raise the cost of ad:usting to product mar)et shoc)s ithout e6change rate change.

Ans er+ 'f the 3ether!ands suffers an unfavorab!e shift in output demand" *utch capita! can f!ee abroad" !eaving even more unemp!oyed *utch or)ers behind than in the case of government regu!ations that ere to hinder the movement of capita! outside the 3ether!ands. Severe and persistent regiona! depressions cou!d resu!t" orsened by the !i)e!ihood that the re!ative!y fe or)ers ho did successfu!!y emigrate ou!d be precise!y those ho are most s)i!!ed" re!iab!e" and enterprising. -his is another e6amp!e of the theory of the second best. ,4. >=iven that !abor remains re!ative!y immobi!e ithin Europe" the European Union(s success in !ibera!i&ing its capita! f!o s may have or)ed perverse!y to orsen the economic stabi!ity !oss due to the process of monetary unification.? *iscuss.

Ans er+ 7robab!y right. -his is another e6amp!e of the theory of the second best. 'f the 3ether!ands suffers an unfavorab!e shift in output demand" *utch capita! can f!ee abroad" !eaving even more unemp!oyed *utch or)ers behind than in the case of government regu!ations that ere to hinder the movement of capita! outside the 3ether!ands. Severe and persistent regiona! depressions cou!d resu!t" orsened by the !i)e!ihood that the re!ative!y

19

fe or)ers ho did successfu!!y emigrate ou!d be precise!y those ho are most s)i!!ed" re!iab!e" and enterprising. ,5. *iscuss the prob!ems that the E.U i!! face in the coming years.

Ans er+ pages 841#84,. C1D Europe is not an optimum currency areaH therefore asymmetric economic deve!opments ithin different countries of the euro &one that ca!! for different interest rates cannot be imp!emented. C,D -he po!itica! part of the unification is much ea)er and may !imit the po!itica! !egitimacy of the economic unification. C4D On the one hand" !abor mar)ets remain high!y unioni&ed and sub:ect to high government unemp!oyment ta6es and other regu!ations impeding !abor mobi!ity. On the other hand" capita! has high incentive to migrate to the E.U countries ith the !o est ages. C5D Constraints on nationa! fisca! po!icy are !i)e!y to be painfu! due to the absence of substantia! fisca! federa!ism Cfisca! transfer of resources from the rich to the !ess rich countries ithin the European UnionD. C9D -he EU is considering a !arge#sca!e e6pansion of its membership into Eastern Europe and the .editerranean. -his i!! cause many coordination costs and a!so the issue of representation of sma!! and big countries.

18

Quantitative/Graphing ro!lems 1. Sho the effects of the reunification of eastern and estern =ermany in 100< on both =ermany and its neighboring European countries using the AA G ** frame or).

Ans er+ @or =ermany" this as a period of boom ith high interest rates to fight inf!ation. Other European countries+ @rance" 'ta!y and UA ere in recession" trying to match the high =erman interest rates to ho!d their currencies fi6ed against =ermany(s" thereby pushing their economies into deep recession. Other European countries tried to continue the fi6ed e6change rate in order not to !ose the credibi!ity they had bui!d up since 1019. -he po!icy conf!ict bet een =ermany and the other European countries !ed to a series of fierce specu!ative attac)s on the E.S e6change parities starting in September 100,. $y August 1004" the E.S as forced to retreat to very ide CF# 1< percentD bands" hich as )ept in force unti! the introduction of the euro in 1004. ,. Using the == G LL frame or)" ana!y&e the effect of an increase in the si&e and freBuency of sudden shifts in the demand for a country(s e6ports.

Ans er+ Such a change pushes LL up ard and to the right. -hus" the !eve! of economic integration at hich it becomes orth hi!e to :oin the currency rises. 'n genera!" increased variabi!ity in the product mar)ets ma)es countries !ess i!!ing to enter fi6ed e6change rate areas. -his prediction he!ps e6p!ain hy the oi! price shoc)s after 1024 made countries un i!!ing to revive the $retton Woods system of fi6ed e6change rates. See a!so Chapter 10. 4. Using the == G LL frame or)" ana!y&e the effect of Libya subsidi&ing the 7a)istani 3uc!ear programs.

Ans er+ -his i!! shift the == curve up ard and to the !eft causing the t o countries to trade more" thus reducing the minimum va!ue for the t o countries to cooperate under a fi6ed e6change rate regime.

12

5.

What is the purpose of the fo!!o ing figure?

Ans er+ -he purpose of the figure is to sho the inf!ation convergence ithin the si6 origina! E.S members. -he figure sho s the difference bet een domestic inf!ation and =erman inf!ation for si6 of the origina! E.S members. As of 1002" a!! nationa! inf!ation rates ere very c!ose to the =erman !eve!s. See @igure ,< in the te6tboo) for a more updated figure.

11

9.

What do you )no about the countries mar)ed in b!ue in the fo!!o ing figure?

Ans er+ -hey are members of the Euro &one as of ;anuary 1" ,<<1.

10