Preliminaries:  The Key Issues of Macroeconomic Management:  Two Key Questions

1. How fast can the economy grow?  What is a sustainable growth rate without generating inflationary pressures? What should the MPC assume the underlying long term growth rate of the economy to be? If it assumes too high a rate, it will generate inflation.  If it assumes too low a rate, monetary policy will be too tight to allow the economy to grow as much as possible.  See above, and also two more (oldish) articles from the Economist on:
• Will the US Economy survive the downturn?
• What is likely to happen when the (US) economy turns down - the effects of a recession.
2. How Big or Small should the Budget Deficit be?
• Current spending by governments (as opposed to spending on Capital Investment) should be balanced by taxation revenues over the course of the economic cycle - automatic stabilisers
• Capital investment (improving the capacity of the economy to generate incomes and output) can justify borrowing (government debts and deficits)
• Total public debt (amounts owed to the private sector) need to be serviced (interest has to be paid).  So there is an upper limit on the total public debt (currently set at 40% of GDP by the UK government)
• Leaves two major questions (to which there are currently no clear answers):
• What counts as capital investment as far as government spending is concerned?
• What is a sensible upper limit on Public Debt?  In other words, how much public debt is the economy and the electorate willing to pay for?
• These two questions are inter-related - the more convinced people are that government spending is capital investment - improving the capacity of the economy to generate incomes, output and well-being - the greater will be its willingness to pay for this investment and bear the costs of a large public debt.  Furthermore, the answers to these questions are essentially political - they need to be answered through public debate, discussion and election.

• The Essence of Macroeconomic Management (what you should have learned!):

• Matching the growth of the economy with its capacity to sustain growth - Ye versus Yf.
• Unsustainable growth rates (Ye > Yf) mean overheating and decay - inflation and (later) unemployment
• Restricted growth rates (Ye < Yf) mean under-utilisation, unemployment, and atrophy
• variations in interest rates, inflation rates, unemployment rates and exchange rates (both over time and between different countries at the same time) are symptoms, not causes, of these imbalances or different balances between yields (actual growth rates) and capacities (potential and sustainable) growth rates.
• Properly interpreted and properly managed, these symptoms (interest rates, exchange rates, inflation rates and unemployment rates) are also signals - what needs to be done and what needs to change to regain the balance between yield and capacity

Is the Euro a Good Thing for the UK?  What is Monetary Union?  What are the advantages and disadvantages of a Common Currency?

What does European Monetary Union actually mean?

• that what used to be international trade (exports and imports) and international capital movements (transactions) now become internal or inter-regional or inter-sectoral trades and transactions. In our Circular Flow of Income representation of the macroeconomy - the boundaries are re-drawn the reduce the flows of imports and exports (which now represent only the trade which happen between the currency area and the rest of the world).
• there will be no exchange rate and no forex market between countries in the Union.
• It also means that, instead of there being several Monetary Authorities (each of the countries' central banks) there is now only one - the European Central Bank (ECB) - so there will be a common monetary policy rather than a combination of somewhat separate monetary policies, and a common interest rate in countries in the Union.

So, what does Monetary Union actually DO?

• reduces transactions costs and uncertainty (far fewer exchange rate variations to worry about);
• and makes inter-regional comparisons of costs, prices and wages more transparent and obvious; changes the signals of economic performance and competitiveness - no longer the exchange rate, but now: differential wages, prices, costs and unemployment rates between regions;
• changes the monetary authority and the conduct of monetary policy - and almost certainly towards 'prudent' monetary policy emphasising stable growth in money supply at about the underlying real growth rate of the economy to avoid inflation (unlike the history of France and, especially, Italy, though more like the German history).

So What?

• The Multiplier will tend to be larger within the Union than in the separate countries before Union, because there are now fewer leakages out of the Unions Circular Flow of Income.  But this is really only an accounting change - the sums are now done over a larger area and greater number of economic transactions than before. The multiplier for the UK will not change much if at all.
• The key difference is that there are fewer "buffers" between different rates of growth and different rates of unemployment and inflation in different areas of the Union:
• Prior to Monetary Union, countries could experience and sustain different rates of growth, inflation and unemployment because these differences were reconciled or buffered by differences in both:
• national interest rates
• exchange rates
• Within the Monetary Union, these buffering mechanisms are removed
• - there is no exchange rate (or rather the exchange rate is fixed and immutable at 1:1);
• there is a common interest rate established by the European Central Bank.
• This means that differences in regional growth rates (Ye) versus the capacities of these regions to sustain these growth rates (Yf) now show up as regional variations in:
• price pressures and levels - higher prices and wages in rapidly growing and rich regions versus lower prices and wages in the slower growing and poorer regions (e.g price of houses, beer, etc. between the south and north of the UK)
• employment rates (higher in the rich and rapidly growing regions and lower elsewhere)
• costs of capital (risk premia on effective interest rates - those which are actually paid and earned) - capital is cheaper where it is plentiful and more expensive where it is scarce and more risky.
• These signals should, according to the logic of markets:
• encourage growth in the slower growing regions and discourage growth in the rapidly growing regions
• encourage people and capital to move from the expensive regions to the cheaper regions.
• But, the extent to which these market signals trigger these changes depends on the extent to which at least some people and some capital are willing and able to move between regions.
• people are more or less attached to their present locations and more or less comfortable with their present communities
• capital finds it easier and less risky to be close to areas of rapid growth - which are characterised by good infrastructure, close networks of related sectors, supply chains, marketing chains, management linkages etc.
• Because people do not want to move, and capital does not want to take unecessary risks
• regional differences and disparities persist in any monetary union (e.g. in the UK at present, or in the US, or in the EU). e.g. the following chart, which shows the relative average growth rates of countries of the EU and regions of the US (a long standing monetary union).
• 
• So, what do people do when they want to preserve their ways of life?  They club together and form communities, and nation states.
• they form national (and regional) governments to protect themselves from their neighbours and traders, who become competitors rather than cooperators
• Monetary Union, then, is a step to removing and reducing these national barriers and protective devices.

Dealing with regional disparities - especially unemployment 'black spots'
This requires fiscal policy to assist high unemployment areas and provide appropriate social security and labour mobility/flexibility programmes. Fiscal policy will still be under national control, though heavily constrained by the Government Borrowing restrictions under the EU Stability Pact - budget deficits no more than 3% of GDP, National Debt no more than 60% of GDP.

Notice - this is a Stability Pact, and not just criteria for EMU members.  It is a pact which seeks to reduce instability between countries and resulting variations in exchange rates.  The UK will be judged and bound by this pact whether inside or outside the EMU itself.

There are questions about whether these constraints are too tight to allow countries to assist adjustment in the 'peripheral' regions, and whether these regions will be evenly distributed within countries or whether some countries might be more 'peripheral' than others.

If these constraints prove too tight for political and economic response to uncompetitive regions and sectors, what will happen? It seems likely that ways round the stability pact will be found (as they already have been in determining the qualifiers for the initial euro area - not all initial members really qualify unabiguously under the budget/national debt criteria.)

These ways might be a larger European Union budget - currently restricted to 1.27% of GDP, and far too small to provide for significant transfers from the better off to the poorer regions. Or they might simply relax the stability pact. It seems (at present) unlikely that the euro will be allowed to break up or fall apart on this count. Member states will find compromises and reconciliations which will resolve these difficulties.  In particular, common fiscal policies will not prove to be acceptable on these grounds, if no others.  Common fiscal policies are NOT part of the monetary union, in spite of frequent proetstations to the contrary.

Is it a good or a bad thing?  You have to make up your own mind:

The critical dimensions of the effects of EMU membership revolve round:

• Whether a common monetary policy will fit the UKs circumstances?  Is the UK likely to experience substantially different economic conditions than the other members, especially once in the system?  What reasons can be advanced to suggest these differences?
• Will the UK respond to a common monetary policy in similar fashion to the other members? The importance of the housing sector in the UK economy relative to some other members might suggest so, but would the housing market adjust to this new circumstance?  Otherwise, why should the UK economy be differently sensitive to interest rates than other economies?

• Pro:  The UK economy has traditionally shown considerable BoP and exchange rate volatility.  This is especially important in times of recession and recovery, where interest rate reductions and stronger growth both tend to lead to exchange rate depreciation (BoP deficits), which increases import prices and might lead to an earlier onset of inflationary expectations than otherwise and thus to premature deflationary policy?  EMU membership would certainly reduce UKs exchange rate volatility, and furthermore, would harmonise exchange rate fluctuations with those of the rest of the euro area, tending to encourage convergence of macroeconomic conditions. Coupled with the arguments about reduced transactions costs, improved competition, and hence imporved growth and investment, the case for membership in principle seems strong. But, the last time we experienced a substantial recovery phase, coupled with substantial depreciation of sterling (1992, when we left the exchange rate mechanism) there was no substantial imported inflation effect, contrary to many predictions.  Furthermore:
• Con:  The UK economy has substantially outperformed the eurozone since 1993:  both began this period with unemployment rates at about 10%, but the UK showed more rapid and larger declines - to about 3% by 2000/1, while the eurozone has shown persistent unemployment at 10% till 1998/9 and is currently experienceing unemployments rates at more than 8% and rising, unlike the UK's which appears stable and low.  Since 1991 (=100) UK real national income has increased to almost 130, while the eurozone stands only at 120. UK growth was only bettered by the Eurozone in one year of these 11 most recent years - in 1992.  The UK's future prosepcts from growth and employment look at least as good if not considerably better than the Eurozone's - so what is the argument which supports change?  But, it might be pointed out, would the UK not have performed equally well if we had been in?  After all, Ireland has managed pretty well. And how much of the eurozone's pooerer preformance is down to the euro experiment?  After all, many of these economies are less flexible than the UKs, which would indicate slower growth and higher rates of unemployment, and  Germany, as  major player, has experienced the substantial economic dislocation of the unification of Germany, which would have occured anyway.  Furthermore, the UK has had the benefit of prudent monetary policy since 1997 (when the BoE became responsible), which has clearly contributed substantially to our better economic perfomance since then.  This prudent management would not go away with euro membership, albeit over a much larger and more diverse economy. Back to the critical issues above.

See here for more thoughts and links on this key question.

• What Did Economists Think (in 1999)?
• Official HMT Euro web site (which also links to other Treasury pages, including the Budget, and Monetary Policy.
  

But this decision is far too important to be left to uninformed debate and "knee-jerk" reactions.  It needs careful thought and consideration.  I hope this course has provided some major parts of the basis for such careful thought and consideration.