Chapter 35 European integration

1
Chapter 35European integration

• David Begg, Stanley Fischer and Rudiger
  Dornbusch, Economics,
• 6th Edition, McGraw-Hill, 2000
• Power Point presentation by Peter Smith

2
Some key issues

• The European Single Market
• what difference did it make?
• Economic and Monetary Union (EMU)
• why did it happen?
• What difference will it make?
• Reform in Eastern Europe
• how are these countries faring in their
  transition from central planning to market
  economies?

3
The Single Market

• Established under the Single European Act of 1987
• with December 1992 as the target date for
  completion
• which was met

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Objectives of the Single Market

• Abolition of remaining foreign exchange controls
  on capital flows
• removal of non-tariff barriers within the EU
• elimination of bias in public sector provisioning
• removal of frontier controls
• with some provisos
• progress towards harmonization of tax rates

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Benefits of the Single Market

• Improved resource allocation
• removal of non-tariff barriers allows more
  exploitation of comparative advantage
• Scale economies
• larger potential market increases the scope for
  economies of scale
• Intensified competition
• may stimulate greater cost efficiency
• Factor mobility
• enables greater efficiency through mobility of
  labour and capital

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Gains from the Single Market
Source Allen, Gasiorek and Smith (1998)
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From EMS to EMU

• A monetary union has
• permanently fixed exchange rates within the union
• an integrated financial market
• a single central bank setting the single interest
  rate for the union.
• The Maastricht Treaty set criteria for EMU entry
• to define convergence
• The single currency area began in January 1999
  with 11 member countries.

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The Maastricht criteria

• Inflation rate
• no more than 1.5 above the average of the
  inflation rate of the lowest 3 countries in the
  EMS
• Long-term interest rate
• no more than 2 above the average of the lowest 3
  EMS countries
• Exchange rate
• in the narrow band of ERM for 2 years
• Budget deficit
• no larger than 3 of GDP
• National debt
• no greater than 60 of GDP

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Sterling and Europe
UK membership of ERM/EMU?
North Sea oil made the UK different
The UK is less integrated with the rest of Europe
but this is changing ...
The UK has a greater tradition of macroeconomic
sovereignty.
Black Wednesday and the ERM crisis
The UKs business cycle was out of phase with the
rest of Europe.
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The economics of EMU

• Optimal currency area
• a group of countries better off with a common
  currency than keeping separate national
  currencies
• 3 key attributes (Mundell)
• countries that trade a lot with each other
• countries with similar economic and industrial
  structures
• flexibility in labour markets

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So is Europe an optimal currency area?

• Europe is quite but not very closely integrated
• Some countries are more closely integrated than
  others
• but the act of joining may itself feed the
  process of integration

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Macroeconomic policy for a small member of
Euroland
A small Euroland member faces a horizontal LM
curve, given that interest rates are fixed by the
ECB.
IS0
LM
r0
If the country is too small to influence the ECB
to alter interest rates, either the country
must wait for wage prices to shift IS back
via improved competitiveness,
Y0
13
Central and Eastern Europe
GDP per capita in 1988/89
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Eastern Europe some key issues

• On the eve of transition
• low per capita income
• high international debt
• Supply-side reforms
• crucial for prices to reflect true scarcity
• Trade and foreign investment
• markets needed for products
• and physical capital/management skills
• Macroeconomic conditions
• firm and credible macro policy needed
• especially to avoid excessive inflation.

15
A progress report on the transition
Growth of real GDP
Inflation