Prices and Interest Rate Behavior in the European Monetary Union: The First 18 Months

By Alonso-Rodriguez, Agustin | International Advances in Economic Research, November 2002 | Go to article overview

Prices and Interest Rate Behavior in the European Monetary Union: The First 18 Months


Alonso-Rodriguez, Agustin, International Advances in Economic Research


Abstract

New ideas on the role of central banks have been exposed in recent years. This paper studies the evolution of the consumer price index and the treasury bill rate in the 11 countries of the European Union that have adopted the euro to see if it could be considered to be consistent with a unified economic policy, as directed by the European Central Bank. This evolution is analyzed during the first year and a half of the existence of the euro. (JEL C31, C39)

Introduction

On January 1, 1999 the euro started out its journey for 11 countries of the European Union. With the euro, the European Central Bank (ECB) took its place as the only monetary authority for these 11 nations.

This paper studies the first year and a half of this monetary union to see if the consumer price index (CPI) and one of the long run interest rates, the treasury bill rate, have evolved in a unified way as a consequence of the existence of the ECB.

The paper is divided into four parts. In the first, some of the characteristics of a monetary union are enumerated and some relevant facts of the European Monetary Union (EMU) are presented. Second, the role of a contemporary central bank is considered, followed by a presentation of the statistical models used for the study's objective, and finally, some conclusions are drawn.

Characteristics of a Monetary Union

A monetary union is the effect of monetary integration in a geographical area. A currency area is formed by countries linked together by fixed exchange rates, while the group, as such, has a regime of floating rates with respect to third party countries. A monetary union like the EMU needs to be achieved in different stages. The first stage would be the establishment of a currency area with irrevocably fixed exchange rates. The next stage would be the establishment of a single currency, and the third stage would generate an integrated market for goods and factors of production, as well as a coordinated economic policy among the member countries. This is not a unique possible scenario. Another possibility could be stage three preceding stage two. In this case, the single currency process would be the crown of the monetary union. The ultimate target of a common exchange rate is price stability.

Some experiences have been promoted and realized in the past. They require the existence of at least two countries, an anchor country and a satellite country. The selected anchor country must exhibit high price stability, while the satellite country or countries should have strong commercial links to the anchor country. An example of this relationship is Germany as the anchor country for Austria and The Netherlands.

A monetary union such as the EMU establishes additional rules such as the creation of the ECB, which in principle tends to break the hegemony power of the anchor country, which is locked into the common central bank and its monetary independence.

After this brief and partial summary of the theoretical aspects of a monetary union, some of its advantages will now be considered. The most relevant benefit of a monetary union is the acceptance of one money as a means of payment among the participating countries. The general and theoretical acceptability may differ between areas and types of transactions. However, when many currencies are present, there are reasons for fixing the optimum number of currencies into one. Some of these reasons are the average holdings of transactions balances will be reduced and the transaction costs are reduced to zero because the exchange rates are fixed at 1:1 [Claasen, 1996, pp. 235-40]. However, some costs are not totally eliminated.

Some Facts About the EMU

The European Economic Community, established in 1958, formed the base for European integration. The EMU has evolved in the following three stages.

On July 1, 1990 the European Community entered the first stage, which led to freedom of capital movements, increased cooperation among central banks, free use of the European currency unit (ECU), and the improvement of economic convergence among member states of the European Union. …

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