With the change over to the Euro notes and coins now complete across the "Euro-zone", twelve countries that have adopted the Euro as their currency, the debate over whether to adopt the single currency in Britain continues. There will be those who argue that the introduction of the single currency is merely the next logical step in the development of a truly single market, and that by joining, Britain would gain a voice in what could eventually become the world's most powerful economic zone. Others believe that a successful common market is not dependant on the adoption of a single currency, which they see as merely another irrevocable step towards the political union of Europe. But the main focus of the debate centers on the parameters of macro economic objectives.
So, assuming exchange risk is a big factor, consider whether joining the Euro will actually reduce it or not and if so by how much. Here we immediately trip over the key point that joining the Euro is not to join a world currency but a regional one. Unfortunately for our exchange risk we trade very heavily with the dollar area. Let us not get tied up in the vexed question of the exact shares of our trade with Europe and with the USA, and what sorts of trade should be counted (in goods? in goods and services? or in all cross-border transactions including foreign investment and earnings on them?). The point is that if we regard exchange risk as a sort of tax on transactions involving exchanging currency, then it is plain that the broadest definition should be used for the trade' affected by this tax. Most of the world outside Europe either uses the dollar or is tied to it in some formal or informal way. We might then say, in a rough and ready way, that we trade and invest half with the Euro area and half with the dollar area.
It so happens that the Euro/dollar exchange rate has been highly variable for a very long time - see Figure 1 which shows the DM/dollar rate up to January 1999 and thereafter links on the Euro-dollar rate (this linkage assumes that the DM would have been the dominating element in the behavior of the Euro, had it existed before). Nor have the sources of that variability been removed. They include the very different philosophies of regulation which lead to swings in market sentiment about likely future success; differences in business cycle timing which cause swings in interest rates; and differences in adoption of new technologies. It is true that differences in inflation are now small but that has been so now for at least a decade and a half; this has not stopped very large swings in the exchange rate due to these other reasons which affect the real exchange rate' (that is, the exchange rate adjusted for relative inflation.)
The problem then for the UK is that if they join the Euro they thereby increase their exchange risk against the dollar as the Euro swings around against it. If they remain outside, the pound can as these swings occur go between' the two, rather like someone sitting on the middle of a seesaw. The chart of the UK's own effective (or average) exchange rate - Figure 2 - juxtaposed against the Euro/dollar exchange rate shows rather clearly that we have been able to enjoy less volatility in our overall exchange rate by tying to neither of these two big regional currencies.
To start, I will discuss the arguments against the UK joining the Euro. The UK government has 3 major macro economic objectives and 2 on a slightly smaller scale: i) a high, but stable rate of economic growth within the UK's potential ii) high, but stable employment iii) low inflation iv) balance of payments equilibrium and v) fair and equal distribution of income.
In order to balance these objectives, governments use policies to control various aspects of the economy, however, in the analysis that follows, it will be shown that the most important of these policies, Monetary policy, would be rendered unusable to control the UK...
Please join StudyMode to read the full document