Transcript Chapter 15: Financial Markets and Expectations

Special Topics in Economics
Econ. 491
Chapter 5:
Convergence Criteria
I. Maastricht Criteria
 The Maastricht criteria (also known as the convergence criteria)
are the criteria for European Union member states to enter the
third stage of European Economic and Monetary Union (EMU)
and adopt the euro as their currency.
 The Maastricht criteria stress three main policies:
1- Attain exchange rate stability defined by ERM (before Euro).
2- Attain price stability
3- Maintain a restrictive fiscal policy
II. Maastricht Convergence Indicators
 Courtiers must conform to rules regarding exchange
rate stability, inflation, interest rates, government
budget deficits, and government debt.
 These are called convergence indicators or
convergence criteria.
 They measure whether the economies follow policies
similar-or convergent- enough to make a common
currency viable.
 All countries that satisfied the criteria were to embark
on currency on currency unification as of January 1st,
1999. Other EU members could join later as they met
the convergence criteria.

The Maastricht treaty requires each EU country
to meet five convergence criteria to participate in
monetary unification:
1. Currency must have remained within its ERM trading
band for at least two years with no realignment.
2. Inflation rate for the preceding year must have been no
more than 1.5% above the average inflation rate of the
three lowest –inflation EU members.
3. Long term interest rate on government bonds during
the preceding year must have been no more 2% above
the average interest rate of the three lowest inflation
EU members.
4. Budget deficit must not exceed 3% of GDP.
5. Government debt must not exceed 60% of GDP.
1. Currency must have remained within its ERM
trading band for at least two years with no
realignment:
Joined the exchange rate mechanism of the EMS and
did not experience a devaluation during the two years
preceding the entrance into EMU
2. Inflation rate for the preceding year must have
been no more than 1.5% above the average
inflation rate of the three lowest –inflation EU
members:
Inflation rate  average of three lowest inflation rates
in the group of candidate countries + 1.5%
3. Long term interest rate on government bonds
during the preceding year must have been no more
2% above the average interest rate of the three
lowest inflation EU members:
Long-term interest rate  average observed in the
three low-inflation countries + 2%
4. Budget deficit must not exceed 3% of GDP:
Government budget deficit  3% of its GDP;
If this condition is not satisfied: budget deficit should
be declining continuously and substantially and come
close to the 3% norm or the deviation from the
reference value (3%) 'should be exceptional and
temporary and remain close to the reference value',
art. 104c(a))
5. Government debt must not exceed 60% of GDP:
Government debt  60%of GDP;
If this condition is not satisfied:
government debt should diminish sufficiently and
approach the reference value (60%) at a satisfactory
pace', art. 104c(b))
III. Why Convergence Requirements
 The OCA theory stresses micro-economic conditions for a
successful monetary union
 Symmetry of shocks
 Labour market flexibility
 Labour mobility
 The Treaty stresses macro-economic convergence
 Inflation
 Interest rates
 Budgetary policies
 Exchange rate convergence (no-devaluation requirement) ;
 It prevents countries from manipulating their exchange
rates.

So as to have more favorable (depreciated) exchange rate
in the union.
 According to the Treaty, countries should maintain their
exchange rates within the 'normal' band of fluctuation
(without changing that band) during the two years
preceding their entry into the EMU.
 Deficit and debt criteria can be rationalized in a similar way;
 A country with a high debt-to-GDP ratio has an incentive
to create surprise inflation
 The low debt country stands to lose and will insist that the
debt-to-GDP ratio of the highly indebted country be
reduced prior to entry into the monetary union
 The high debt country must also reduce its government
budget deficit
 Countries with a large debt face a higher default risk;
 Once in the union, this will increase the pressure for a
bailout in the event of a default crisis.
 No-bailout clause was incorporated into the Maastricht
Treaty.
 But is this clause credible?
 Interest rate convergence;
 Excessively large differences in the interest rates prior to
entry could lead to large capital gains and losses at the
moment of entry into EMU
 However, these gains and losses are likely to occur prior to
entry because the market will automatically lead to a
convergence of long term interest rates as soon as the
political decision is made to allow entry of the candidate
member country
IV. How to fix the conversion rates during the
transition
 Madrid Council of 1995 implied that on 1 January 1999 one
ECU would be converted into one Euro
 At the same time the conversion rates of the national
currencies into the Euro had to be equal to the market rates of
these currencies against the ECU at the close of the market on
31 December 1998
 This created potential for self-fulfilling speculative
movements of the exchange rates prior to 31 December 1998.
 The effect of such speculative movements could be to
permanently fix the wrong values of the exchange rates.
 In order to avoid this, the fixed rates at which the currencies
would be converted into each other at the start of EMU were
announced in advance;
 If these announcements were credible, the market would
smoothly drive the market rates towards the announced
fixed conversion rates
 This is exactly what happened. The authorities announced the
fixed bilateral conversion rates in May 1998
 Transition was very smooth with minimal turbulence
Table 6.1 Conversion rates of EMU currencies into the euro.
Belgian franc
Spanish peseta
Irish punt
Luxembourgish franc
Austrian schilling
Finnish marka
Geraman mark
French franc
Italian lire
Dutch guilder
Portuguese escudo
40,339900
166,386000
0,787564
40,339900
13,760300
5,945730
1,955830
6,559570
1936,270000
2,203710
200,482000
V. Calculating the Common Currency
(Unified Currency)
 It is possible to define the par value of the unified currency.
 One method to calculate the par value of the unified currency
is based on the weighted GDP.
 The other method to calculate the par value of the unified
currency is based on the weighted bilateral trade.
 According to both methods, the exchange rate of the unified
currency versus other external currencies is determined.
 The exchange rate of the national currencies ( for the
Monetary Union Members) versus the unified currency can
also be determined .
Calculating the par value of the unified currency based on the
weighted GDP.
(1)
Exchange Rate
of US Dollar v.s
National
Currency ($/x)
(2)
Nominal
GDP
( in million
US Dollar)
Country A
0.2666
348 673
51.16%
0.13641
Country B
0.2747
52 723
7.74%
0.02125
Country C
0.2722
163 167
23.94%
0.06518
Country D
3.4630
101 905
14.95%
0.51776
Country E
2.6595
15 121
2.22%
0.0590
Total
681 589
(3)
(3 X 1)
The
Par Value
Weight
( # 2/
total)
0.79961
Calculating the Conversion Rates of the National Currencies
versus the Unified Currency based on the weighted GDP.
Conversion Rates of national
Currencies v.s Unified Currency
(National Currency /Unified
Currency)
Country A
2.99857
Country B
2.91061
Country C
2.93660
Country D
0.23089
Country E
0.30065