Monetary Union

Only 11 member countries of the European Union initially accepted a new currency named the euro, though the number later extended to 17 states. The currency offered the strength of stability in the eurozone. In fact, the formation of the European Monetary Union represents a grand vision to integrate Europe and its historical significance. By signing the Rome and Paris conventions, European countries have created the legal base for the European Monetary Union. Since then, EU member states have advanced significantly. The formation of the monetary union has enabled the creation of a common market, which also includes free movement of capital, people, and goods.

The implementation of the euro has been one of the most courageous historical attempts. However, it poses significant challenges and has drawbacks, because countries participating in the EMU are not identical. The prime objective of the EMU is to offer its member states a variety of benefits by using the single currency and mitigate the negative implications of trade and fiscal deficit in the eurozone.

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Disadvantages for EU Member Countries Joining the Monetary Union

The formation of the EMU has increased trade in the eurozone. It has enabled the division of labor and has disciplined the governments of member states, who before joining the Euro area used monetary and fiscal policies to accomplish populist objectives. On the other hand, the euro is not an ideal instrument. Its prime disadvantage is that it acts as a fiduciary currency. The demand currencies are not built on a real standard, but merely on the trust of people. Additionally, the euro has a significant drawback because the ECB has the power to implement discretionary monetary issues, which permit the use of policies that are identical to those used by member countries with their own currencies.

In need of a real standard, the European Central Bank possesses the power to devaluate the euro and can even finance the fiscal deficits of the member nations. In fact, this has occurred recently, when the ECB exercised monetary emissions and accepted the junk bonds of Greek national government. It acted like a state government which encountered difficulties in financing excessive government expenditures and applied the technique of deficit monetization. By doing so, the ECB violated the underlined principles of euro convergence. Hence, the euro cannot guarantee the exercise of effective long-term national policies (Beetsma & Giuliodori, 2010). To some extent, the euro has prevented the dangers from surfacing due to the fiduciary characteristics of former currencies of EU member countries, such as drachma, escudo, or peseta, but could not eliminate the dangers arising from discretionary monetary issues and of a deficit budgetary policy.

The second disadvantage of the EMU and the euro as the single currency is the large-scale centralization of policy decisions at the European Union level. Major powers lay in the hands of powerful member countries, which endangers the fundamental principle of the EU – individual liberty. This concentrated decision-forming authority can increase the chances of providing undue financial benefits to leading EU countries. Moreover, the effect of inaccurate decisions can be massive, because it would impact 350 million citizens of EU countries directly (Poeck, 2010). Certainly, with the introduction of the euro, the member countries cannot apply a direct pressure on their own central banks so as to monetize their fiscal deficits, but the advantages of a single monetary policy can be ruined by the influential leaders of the EU countries.

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Another major drawback of the EMU is that it restricts the freedom of choice for EU citizens. While national currencies were still available, there existed a money market through which EU citizens could keep wealth in a currency which best suited their personal purposes (Poeck, 2010). With the adoption of the euro, this freedom of choice has been greatly reduced.

Difficulties in Conducting Monetary Policy

The European financial crunch has force many to rethink the effectiveness of the European monetary policy, because the member states participating in the European Monetary Union are not identical. Until now, some countries demonstrated structural differences in development levels. They have a different macroeconomic history in terms of exchange rates and inflation. Hence, the application of an identical monetary policy and maintaining identical interest rates for all eurozone countries poses significant challenges to the European Central Bank in conducting the monetary policy. The mechanism through which decisions of monetary policy impact the member countries and the price level is termed the transmission process of monetary policy. The transfer of monetary impulses to any real sector requires different actions and mechanisms by economic agents during the transmission process. The implementation of monetary policy involves considerable time to influence price developments. Additionally, the strength and the size of different impacts can differ according to the economic state of the country, which poses difficulties in estimating the impact on a real sector (Bukowski, 2011). Hence, the European Central Bank finds itself confronted with variable, extended, and uncertain delays in conducting the monetary policy.

Moreover, identification of the transmission process of monetary policy is critical due to the fact that the economic development of each member country is continuously impacted by shocks from a variety of sources. For example, changes in prices of oil, precious metals, and other commodities can have a short-term effect on inflation, which ultimately creates difficulties in the implementation of a unified monetary policy. The chain and effect of linking monetary policy to price levels begin with an official change in the interest rates established by the ECB on its own operations. In these operations, the ECB provides base money to national central banks. The banking process demands that currency provided by the ECB must fulfill the local demands of people for the currency, maintain interbank balances, and meet the demands for minimum reserves, which must be maintained with the ECB (Pisani, 2013). Due to its weaker control over national government banks, the ECB cannot manage the interest rates on lending. Since the national banks influence the funding cost of liquidity, they should transfer these costs to their customers.

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Difficulties in Managing Government Budget Deficit

The global economic crunch has had a massive effect on the functioning of the EMU, and it has largely been responsible for most of the fiscal problems of the European member states that are known as PIIGS (Portugal, Ireland, Italy, Greece, and Spain). The dramatic appreciation in the government deficit of national governments has discouraged investors from granting new loans because they fear bankruptcy, particularly in the case of Greece. In the case the EMU collapses, the crisis could be more severe due to the fact that French and German banks, which hold the massive debt of Greece, could encounter serious problems (Issing, 2011). Hence, the EMU must safeguard the interests of other member countries by helping Greece, creating further fiscal deficits.

The financial turmoil that started in Greece resulted in a crisis of the EMU as a whole. Undoubtedly, the prime responsibility lies on the Greek government and the situation demands drastic changes in its fiscal and economic policy. Financial institutions and the EMU hold responsibility for converting the Greek crisis into a systemic turmoil. If every member country does not follow common rules of EMU, it will lead to the disintegration of the eurozone (Taylor, 2010).

Fiscal policies have a significant effect on inflation and economic growth of member states and impact their budgets. This is especially true, when it relates to the level and structure of government revenue and spending, as well as managing budget deficits and debt. Unbalanced government expenditure may create short-term demand and inflationary pressures, forcing the EMU to increase interest rates more than necessary. For example, a massive increase in government expenditure that encourages aggregate demand can create inflationary pressure when the national government is already operating at full capacity. Budgetary imbalances can also weaken confidence in the monetary policy of the EMU, particularly when national governments expect that excessive government lending will be adjusted by the European Central Bank (Grauwe, 2010). Additionally, high levels of state borrowing can put financial stability at risk and force the ECB to interfere so as to ensure the effective functioning of the monetary transmission system. Such levels of government borrowing may also have adverse impacts on the lending mechanism of the EMU.

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Conclusion

The formation of the EMU is one of the biggest achievements in the European integration process. The EMU promotes the unification of a democratic Europe both practically and symbolically. Its ideals include free movement of trade, investments, and people.

The introduction of the euro has had both positive and negative impacts. In principle, a single currency promotes specialization and expands national markets into wider ones. It also decreases transaction costs produced by currency risk and offers advantages from international trade. Moreover, the introduction of the euro has also produced many disadvantages, such as currency with fiduciary characteristics, the monopoly of the ECB, centralization of decision–forming power in the hands of powerful member countries, and the absence of freedom of choice for the euro area citizens in currency matters. Hence, the euro helps boost political centralization of Europe instead of encouraging free trade, labor, and capital.

The global financial and economic crisis had a significant effect on the EMU and its fiscal policies. Additionally, it led to a large budget deficit in some of its member countries. Finally, it should be noted that the euro can act as a powerful driver of convergence, which will promote the objectives of monetary policy.

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