Effects on the national economy of UK entry into monetary union

Twelve EU countries adopted the Euro as their currency on January 1st 2002. Only three EU countries remain outside: Denmark, Sweden and the UK. Countries joining the EU after 2004 will also adopt the Euro.

The UK government is in favour in principle of joining the Euro, but it has promised a referendum so that British people can take the final decision.

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Joining the Euro will affect UK in many ways

* Inflation

Britain has a low inflation level in recent years. Joining the Euro Britain will be forced to have European interest rates which have been much lower than British ones, which will be leading to a boom on inflation. However, for a long-term point of view, joining the Euro will have effect on prices. Britain has generally higher prices than the rest of Europe, if firms want win the bigger competition; they would have to bring prices down to the lowest level, because it will be easier to directly compare prices without having to convert currencies. British consumers can easily see if they were being charged more, they would be expecting the same prices as Europe. So firms will have to keep prices in check and cut the prices if needed. For example, British car dealers would have to cut their prices because of car prices are much cheaper in Europe.

* Interest rates

Interest rates are the most important matter for consumers. Joining the euro zone UK short term interest rates would likely be lower on average than they would be if the UK were to stay out of the euro and keep the pound. UK short term interest rates have been higher than German or euro interest rates. UK borrowers would gain and savers would lose as rates fall. Joining the euro would have an impact on eurozone interest rates as well.

* Trade and investment

Different currencies is a barrier to trade, partly because of the cost and trouble of converting currencies, but also because fluctuate exchange rates can damage profits. Getting rid of foreign exchange costs will boost trade, making it easier for cheaper goods from Europe to higher cost British goods. Britain companies will be joining the largest single market in the world outside the US by joining the euro. It will enable businesses to sell more widely, achieving greater economies of scale. It will also enable families and businesses to buy from a wider and cheaper range of suppliers. Both of these will boost trade and increase the prosperity.

Many foreign companies invested in the UK to have access to the EU’s common market. But some foreign manufacturers are switching new investments to other countries. Joining the euro will bring more investment to UK. Reduced borrowing costs would encourage more investment by firms and growth, as British interest rates fell to European levels, and UK home buyers would enjoy cheaper mortgages.

But since Britain has been part of the European single market for a long time, business can already buy from suppliers in different countries, and most of trade barriers has been moved away, having the same currency may make little difference.

* Unemployment

Joining the euro will bring more jobs to Britain as foreign investors come in and British businesses become more competitive, but only if Britain join the euro at a sustainable exchange rate. Because Britain joined the Exchange Rate Mechanism at a very high exchange rate, exporters becoming expensive and they have to increase interest rates in order to stay in. Fluctuating exchange rates mean risk for businesses which export their goods. The Euro takes away that risk.

More labour mobility would be an advantage, but people do not even move around within countries searching for work.

The benefits of Economic and Monetary Union (EMU)

The benefits for EMU consist of four main elements:

The reduction in transactions cost of changing currency

The reduction of exchange risk leading to greater trade and foreign investment with the rest of Europe

Embodied in the cost of raising capital

Increased transparency in price comparison

The political gains of closer union and cooperation brought about the greater closeness of economic relationships within EMU

Conclusion

EMU membership for the UK could enhance productivity by increasing trade flows between the UK and other EU nations; boost investment and stimulate competition in product markets. It could also help to promote supply side reforms in the EU and encourage specialisation and further exploitation of UK’s comparative advantage in several sectors of the economy in the longer term.

The main danger of the euro is the same interest rate because the British economy is so different with those of mainland Europe. For example, Ireland overheated and ended up with rising inflation because it had to cut interest rates to German levels in the middle of its economic boom. Joining the euro may mean greater stability for the currency, but it will replace an unstable exchange rate with unstable interest rates.

Britain is doing well outside the euro with a low tax, flexible economy and long term economic stability, but the single currency euro is developing, joining the euro would benefit both businesses and consumers and make businesses more competitive.

Although there are economic advantages to joining the euro, the government has to be careful about the potential costs. The costs for UK businesses of adopting the euro would be massive – notes and coins would need to be replaced, along with cash registers, cash dispensing machines, accounting systems etc. The retail sector would have to undergo a complete renovation of cash systems. The costs of this changeover would affect all businesses in the UK, whether or not they trade with Europe and whether or not they will benefit. Consumers and businesses would have to pay for these costs through higher prices and taxes. It would take years before the trivial day-to-day savings on European transactions outweighed the costs of the changeover.

Action taken by the UK government to manage fluctuations in EU exchange rates

Exchange rate systems for the UK since 1944

1944-72: fixed exchange rates

1972-90: managed floating

1990-92: semi-fixed exchange rates

1992-01: floating exchange rate

The below graphs show the fluctuation of exchange rates of sterling against Spanish Peseta, German Mark and French Frank for the last 5 years.

(Data from http://www.oanda.com/convert/classic)

The UK’s current monetary policy framework has evolved from past experiences and circumstances. The aim of policy is price stability; the instrument is the official interest rate. The framework in which monetary policy is conducted has gone through several changes.

During the 1950s and 1960s Britain maintained a fixed exchange rate against other currencies. For example one pound was worth about 14 German marks. Britain’s economy was badly run during this period, exports could not keep pace with imports growing much faster and there was an ever-larger deficit of the balance of payments.

Up until the 1970’s, monetary policy included direct controls on banks lending limit which allowed undertaking. People could only borrow the amounts within the limit. These controls had been abolished by 1980; monetary policy was managed by trying to control the overall amount of money in the whole economy. Targets were set for the growth of money and followed interest rates were varied.

It was not worked very well, so by the mid 1980s, monetary policy was based on an assessment of a wider range of economic indictors rather than a single measure of money supply growth.

Exchange rate targets

An exchange rate target is to link monetary policy in UK and inflation with those others. In the late 1980s, monetary policy was being constrained by government’s objective of holding the exchange rate at a certain level.

In 1990, UK entered the European Exchange Rate Mechanism (ERM), monetary policy had to be set to ensure that the pound did not strengthen or weaken by more than a certain amount against other currencies in the system.

In 1992, differences in economic conditions across Europe created tensions between setting the interest rate to maintain the exchange rate and that required for the domestic economy. In particular, the reunification of West and East Germany led to strong growth and inflationary pressures there. Consequently, German interest rates were high. The UK, on the other hand, was emerging from recession, with slow growth and falling inflation. Maintaining sterling’s position in the ERM limited the scope for reducing interest rates below those in Germany to a level that would have been better for the UK economy. Investors had little confidence in UK policy and did not want to hold sterling. The resulting downward pressure on sterling’s exchange rate culminated in a suspension of ERM membership on 16 September 1992 and a sharp depreciation of the exchange rate. (http://www.bankofengland.co.uk/targettwopointzero/mpframework/monetaryPolicyInUK.htm)

Since autumn 1992, Britain has adopted a floating exchange rate system. The Bank of England does not actively intervene in the currency markets to achieve a desired exchange rate level.

In contrast, the twelve members of the Single Currency agreed to fully fix their currencies against each other in January 1999. In January 2002, twelve exchange rates become one when the Euro enters common circulation throughout the Euro Zone.

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