European Fixed Currency

International Economics

Within the EU, countries have different production levels. Italy, Portugal the most southern European countries are going through the development stages, which they need to stimulate their economic growth. Therefore imbalances were built up over the last decade as massive capital flows moved from the North to the South of the Monetary Union. What is different is that in Spain and Ireland, foreign capital was used to sustain massive construction booms (which may not boost the economy in a short period but builds up potential for economy and stimulating the economy in the long run) whereas in Greece and Portugal, foreign capital was used to finance consumption. (which only stimulates the economy in short run and worsens the current account balance).

Southern Europe became uncompetitive because their domestic demands are largely financed by the capital inflows. This contributes to the imbalances and implies that exports have to pick up quickly however because of the single currency they cannot adjust their interest rate and or devalue their currency meaning that they cannot be competitive in the global market or even within Europe. The export cannot rise significantly. The situation can be worse if there is an economic shock. During a crisis, we would expect the currencies of those deficit countries to depreciates in order to boost exports however since the form of Euro, they can no longer to cut the interest rate or devalue their own currency to stimulate the economic growth. It brings a hard time to recover and hence widening the imbalance.

We can analyze Theoretically, according to the Uncovered Interest Parity condition, R=R*+〖∆E〗^e/E, since the adaption of Euro, 〖∆E〗^e/E=0, interest rate are equal to other countries’ within the European Union. Any country within the Euro Zone cannot adjust its interest rate