Pros and cons of Monetary Union

The June F585 case contrasts Latvia and Iceland. For Latvia the benefits of monetary union within the EU outweigh the costs and help justify adopting a fixed (pegged) exchange rate. 

Here is a summary diagram for revision purposes

Pros and cons of a floating exchange rate system

In the F585 Summer 2014 case study, Latvia uses a fixed exchange rate system. Iceland operates a floating exchange rate system. So be sure to know the pros and cons of each system

Floating exchange rate benefits

• Automatic adjustment mechanism for any balance of payments disequilibrium
• Frees monetary policy to target alternative objectives instead of a fixed exchange rate
• Reduces need to hold foreign currency reserves – which have an opportunity cost

Floating exchange rate drawbacks

• uncertainty about future export and import prices may deter investment 
• encourages indiscipline if govt and firms rely on devaluation to restore competitiveness 
• Automatic BoP adjustment mechanism only works if demand is price elastic

Fixed exchange rate benefits

• Reduced exchange rate uncertainty so encouraging domestic investment and FDI 
• Should eliminate destabilising speculation 
• Reduced costs as no need to hedge 
• Imposes discipline on domestic firms

Fixed exchange rate drawbacks

• No automatic balance of payments adjustment as with a floating exchange rate
• Requires high levels of foreign currency reserves which have an opportunity cost 
• Reduced flexibility for monetary policy as interest rates are targeted at a stabilising the exchange rate rather than say inflation ie conflicting macro policy objectives
• Setting the 'wrong' exchange rate (where REER is >) 1 reduces international competitiveness and encourages speculative attacks

However countries seeking monetary union and its associated benefits within the EU must first adopt a fixed rate exchange rate system which helps explain why Latvia pegged its currency to the euro so as to be able to enter full monetary union in Jan 2014

F585 Core Concepts: a checklist

This is a first list and there may be errors and omissions but my advice to those revising for F585 is be sure to understand

Macroeconomic performance

Trend growth and output gaps

Causes of short and long run economic growth - especially FDI and international trade

Multiplier and multiplier effect

Accelerator effect

Fixed exchange rates

Floating exchange rates

Balance of payments problems and particularly international competitiveness

Purchasing power parity and real effective exchange rates

Terms of trade

Foreign direct investment and multinationals

Globalisation

Fiscal rules

Inflation targeting

Policy trade offs

Pros and cons of monetary union

Economic development

Sustainable economic development

Role of the International Monetary Fund, World Bank and WTO

Revision video: the current account

Here is a revision video of all the elements of the current account with minimal coverage of the capital and financial account. Watch in conjunction with the ONS The current account balance video

Labelling exchange rate diagrams

Here is a tip for remembering how to label the axis of exchange rate diagrams

Horizontal axis: measures quantity of currency traded eg number of € bought and sold

Vertical axis: measures the price of a currency ie how much of another currency eg $ one unit of domestic currency eg € can buy

Here is an example for Euro exchange rate diagram against the $

Revision video : analysis of a depreciation of sterling

Here is a revision video analysing the impact of a depreciation of sterling on AD and the current account.

The Marshall Lerner condition is only required for A2

Factors affecting C I G and X-M

Remember: the AD curve will shift if C I G or X-M change. C I G and X-M will change if any of the above factors change.