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The transition to a monetary union

6 important questions on The transition to a monetary union

On which two principles was the Maastricht Treaty based?

1. the transition towards a MU was seen as a gradual one
2. entry into the union was made conditional on satisfying convergence criteria

What were the convergence criteria?

1. its inflation rate is not more than 1.5% higher than the average of the 3 lowest inflation rates
2. its long term interest rate is not more than 2% higher than the average observed in these 3
3. it has joined the exchange rate mechanism of the EMS and no devaluation in the past 2 years
4. budget deficit not higher than 3% of GDP (or decreasing to it)
5. debt should not exceed 60% of GDP (or approach it)

Where do the 3% deficit and 60% debt ratios come from?

d = gb where b is the steady state level at which debt is stabilized (percentage of GDP) and d is the government budget deficit (percentage of GDP), g is growth rate

In order to stabilize debt at 60%, the budget deficit must be 3%, if the growth rate is 5% (0.03 = 0.05 x 0.6)

arbitrary: why 60%? > This was average debt at the time.
Countries with higher growth rates can have higher budget deficits

Why must interest rates converge?

Otherwise capital gains/losses will be made when entering the MU.
Suppose the UK wants to join, with a long-term bond rate of 5%. The long-term bond rates in euros is 3%. Bondholders want to sell low yield euro denominated bonds and buy high yield pound bonds. Since exchange rate is fixed (no exchange rate risk) this will continue until the return on euro and pound bonds are equal. Economic agents holding euro bonds will make capital losses, those with pound bonds will make gains > disturbances in capital markets.

What was the main problem in the transition to the EMU?

Related with the exchange rates of the national currencies with the euro. The conversion rates of the national currencies into the Euro had to be equal to the market rates when the market closed > potential for self-fulfilling speculative moments prior to the closing. Any movement on the last day would be self-validating, possibly causing permanently fixing wrong values.

> avoided through the credible announcement long enough in advance.

How to organize relations between the ins and outs?

The (voluntary) ERM and ERM-II: the new mechanism is based on central rates around which margins of fluctuations are set. The latter is quite wide, the anchor of the system is the euro.
Lithuania adheres because it wanted to join the Eurozone, Denmark adheres because it wants to stabilize the currency towards the euro.