Academic journal article Atlantic Economic Journal

The Euro and Its Consequences: What Makes a Currency Strong

Academic journal article Atlantic Economic Journal

The Euro and Its Consequences: What Makes a Currency Strong

Article excerpt


"The introduction of the euro was one of the great events in economic history after World War II. The breakdown of the Bretton Woods system shifted the international monetary system from fixed exchange rates to a system of floating exchange rates. Before and after the breakdown, however, the U.S. dollar was the dominant currency in the system. The creation of the European Central Bank (ECB) and of the eurosystem introduced a new strategic element, it changed the power configuration of the international monetary system. Let me quote R. Mundell [1998]:

"The introduction of the euro, on the other hand, will challenge the status of the dollar in the international monetary system and change the power configuration. For this reason the introduction of the euro may be the most important development since the dollar replaced the pound sterling as the dominant international currency in World War I."

The history of the European monetary integration was characterized by a slow but steady progress accompanied by scepticism and the prediction of catastrophes [Feldstein, 1987]. Many observers considered Stage Three of the introduction of the Economic and Monetary Union in Europe as infeasible and as a leap into darkness. An important question raised was whether a single currency was appropriate for different European countries. A fierce scholarly debate developed based on Mundell's [1961] classic paper "A Theory of Optimum Currency Area." Not only the euro optimists but also the doubters who opposed the EMU used arguments from this classical AER article [cf. Horvath, 2001].

However, on 1 January, 1999, the euro was successfully introduced and a single central bank, the ECB, assumed responsibility for monetary policy in the euro area, the second largest economic area after the United States. The euro countries account for 16 percent of world GDP and 19 percent of world trade. They are thus comparable with the United States which accounts for 22 percent of world GDP and 15 percent of world trade. The transfer of responsibility for monetary policy from 11 national central banks (which have since become 12) to a single supranational institution represented a milestone in the European integration process. On 1 January, 2002, euro notes and coins started to circulate in the 12 countries of the euro-area.

The euro became a tangible currency. Now that the euro has existed for three years we can try to give an assessment of the euro's global role, in particular, vis a vis its principal rival, the dollar. We can attempt an evaluation of the monetary strategy of the ECB compared with that of the Fed and finally try to identify some fundamental factors underlying the development of the exchange rate of the euro.

The paper is organized as follows. In section two the monetary strategy of the ECB is compared with that of the Fed. In the third section we analyze the global role of the euro and the dollar. Section four focuses on the unexpected depreciation of the dollar during the three years of the euro's existence. In section five we draw a few conclusions.

The Monetary Strategy of the ECB

When the ECB started its operations in January 1999 it was confronted with the difficult task of conducting monetary policy in a completely new environment. The incomplete and highly uncertain knowledge of the monetary transmission process suggested the formulation of a new monetary policy strategy. The ECB calls its new approach stability oriented monetary policy strategy [ECB, 1999a].

It is comprised of three main elements:

1) a quantitative definition of price stability (the anchor)

2) a reference value for M3 growth (the first pillar)

3) a broadly based assessment of price developments (the second pillar)

The eurosystem defines price stability as a year-to-year increase in the Harmonized Index of Consumer Prices (HICP) (1) for the euro area of less than 2 percent. …

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