The Impact of Euro Strengthening to the EMU Economy

8/14/2019 The Impact of Euro Strengthening to the EMU Economy

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This work or any part thereof has not previously been presented in any

form to the Hogeschool Holland or to any other institutional body whether

for assessment or other purposes. Save for any express acknowledgments,

references and/or bibliographies cited in this work, I confirm that the

intellectual content is the result of my own efforts and no other person

________________________ Jenny Setiawan

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ACKNOWLEDGEMENT

This dissertation has been written as final requirement for achieving the Bachelor or Arts inInternational Business and Management Studies at INHOLLAND University.

I would like to express my gratitude to several people without whom this dissertation cannot be

actualized the way it did. First, I am grateful for David Wilson for his commitment, guidance,

and support throughout the process and for not only being my dissertation supervisor but also my

motivator. Marinella Kramer de Moya, as my second marker, for his availability and enthusiasm

in my dissertation. Keith Medhurst, for his genuine support and inspiring conversations. Next, I

would like to thank my Business Research Methods lecturer, Menno van Voortuizen, for his

knowledge in his area that has saved me from reading over adequate information. Rene van der

Linden, the European Business Environment lecturer, for his expertise and directions in

orchestrating the economic issues related to my dissertation.

Thank you all!

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CONTENTS

ACKNOWLEDGEMENT ............................................................................................................... 3 CONTENTS ................................................................................................................................... 4 LIST OF CHARTS AND TABLES ................................................................................................. 6 GLOSSARY ................................................................................................................................... 7 EXECUTIVE SUMMARY ........................................................................................................... 10 1.RESEARCH AIMS............................................................................................................................. 12

1.1 Research Questions ..................................................................................................... 12 1.2 Significance of Research .............................................................................................. 13 1.3. Methodology ............................................................................................................. 13

1.4. Dissertation Framework .............................................................................................. 13 1.5. Limitation ................................................................................................................. 14

2.INTRODUCTION............................................................................................................................... 16

2.1. Integration economy and monetary in Europe ................................................................. 17 2.2. Deterioration of US economy ....................................................................................... 17 2.3. Real Interest Rate Differentials ..................................................................................... 18 2.4. Emerging Asian Countries ........................................................................................... 19

3.RELATIONSHIP OF EURO AND THE EMU ECONOMY............................................................ 20

3.1. Inflation .................................................................................................................... 21 3.2. Interest rate ................................................................................................................ 21 3.3. Money Supply ............................................................................................................ 21 3.4. Trade Balance ............................................................................................................ 22 3.5. Gross Domestic Product .............................................................................................. 22 Is the Euro overvalued? .................................................................................................. 22

4.THE EFFECTS OF EURO STRENGTHENING TO EMU ECONOMY......................................... 25 5.POLICIES TO ADJUST MACROECONOMIC ISSUES CAUSED BY EURO STREGHTENING ................................................................................................................................................................28

5.1 Monetary Policy .......................................................................................................... 29 5.2. Discretionary Fiscal Policy .......................................................................................... 31 5.3. Sterilised Intervention Policy ....................................................................................... 34 5.4. Recommendation to EMU ........................................................................................... 36

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LIST OF CHARTS AND TABLES

Charts:

Chart 1 Detailed Methodology..14

Chart 2 Euro-dollar Development.15

Chart 3 EMU vs. US Interest Rate.18

Chart 4 World Real GDP Growth..19

Chart 5 Euro/dollar: nominal exchange rate and PPP...23

Chart 6 Demand Shift in EMU and US25

Chart 7 Euro Area Indices of Consumer Prices26

Chart 8 Expansionary Monetary Policy Mechanism28

Chart 9 Contractionary Fiscal Policy Mechanism31

_____________________________________________________________________________

Table:

Table 1 The Big Mac Index. 23

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GLOSSARY

Aggregate Demand : total spending on goods and services made in the economy. (Sloman

and Hinde, 2007)

Aggregate Supply : the total amount of output in the economy (Sloman and Hinde, 2007)

Balance of Payment : the value of all transactions between a countrys residents and the restof the world (Rugman, 2006)

Budget Deficit : the excess of central governments spending over its tax receipt (Sloman andHinde, 2007)

CPI : Consumer Price Index, economic indicators constructed to measure the changes over time in the prices of consumer goods and servicesacquired, used or paid for by households. (Eurostat)

Deflation : a period of falling prices; negative inflation (Sloman and Hinde, 2007)

ECB : European Central Bank

EMU :European economic and Monetary Union , the process of harmonising the economicand monetary policies of the Member States of theUnion with a view to the introduction of a singlecurrency, the euro (EUROPA.)

Equilibrium : a position of balance. A position from which there is no inherent tendency tomove away (Sloman and Hinde, 2007)

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Open Market Operation : the sale (or purchases) by the authorities of governmentsecurities in the open market in order to reduce (or increase) money supply (Sloman and Hinde, 2007)

PPP (Purchasing Power Parity) : the rates of currency conversion that equalise the purchasing power of different currencies by eliminating thedifferences in price levels between countries (OECD,2001)

Price Stability : Alan Greenspan (1989) defined price stability as expected changes in theaverage price level are small enough and gradual

enough that they do not materially enter business andhousehold financial decisions (King, 2002)

Real Exchange Rate : the price of foreign (currency) relative to domestic goods and service(Copeland, 1989)

Trade Balance : The trade balance is the difference between exports and imports of goods andservices (OECD)

Unemployment : the number of people who are actively looking for work but arecurrently without a job (Sloman and Hinde, 2007)

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EXECUTIVE SUMMARY

In the European Economic and Monetary Union (EMU), the single currency the Euro has been relentlessly appreciating consecutively for five years during its seven years of existence.The Euro reached its 27-year high at 1.4872 in November 2007 rising over 23 percent sinceDecember 2005. Along the Euro development course, EMU economic condition has recoveredfrom struggling with recession to its present vigorous economic state.

Nevertheless, exchange rate movements influence the performance of other macroeconomic

elements such as price, export-import, inflation, output, employment, and growth. Theseelements have reciprocal relationships with exchange rate which means, changes in theseelements influence exchange rate movements in return.

Signs of economic slowdown have arisen in the course of Euro appreciation. The high externalvalue of the Euro is not reflected in the economic statistical data. Thus, the equilibrium value of the Euro is open to discussion. Moreover, it is open to debate as to what extent the EMUauthorities will hold on to current policies whilst aiming to maintain the economic stability andgrowth outlook. For that reason, the following need and scope exist:

1. to assess the performance of Euro appreciation2. to identify impact of the Euro strengthening to the EMU economy.3. to analyse the appropriate policies to adjust the imbalances.4. to assess the cost and feasibility of such policies

Next, the challenges for EMU authorities lie in the policy making to adjust the impact. Thisdissertation is an exploratory research to adequately explain the relationship of Euro

strengthening against the US dollar and EMU economy. The study is based on macroeconomic approach on EMU economy. Literature reviews to identify the area of imbalanceswere conducted. Statistical data from reliable sources were analysed to support arguments of theEuro strengthening impacts with solid evidence. Three macroeconomic policy approaches are being proposed as recommendations to adjust the imbalances. Next, hypotheses of transmissionmechanisms are presented to provide descriptive idea of how policy changes affect the

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performance of economic elements and to communicate the argument on the cost and feasibilityof implementing such policies.

In conclusion, Euro appreciation has caused imbalances to the EMU economy. The rightmacroeconomic policy is needed to adjust these imbalances. Thus, this dissertation is intendedto contribute recommendations to EMU authorities in assessing the best policy approach.

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1. RESEARCH AIMS

Since its inception in 1 January 1999, the Euro experienced two years of depreciation followed

by appreciation for the subsequent 5 years. Reaching over its 27-year high at 1.4872, it isquestionable that the performance of Euro reflects the current economic condition of EMU.Beside the robust performance in the Euro Zone and the emerging of Asian countries,apparently, the weakness of the dollar is perceived by the market as the most likely reason.Despite, the sluggishness shown in the economic data, the ECB and government still hold their current macroeconomic policy unchanged. Therefore, it is open to debate as to what extent theEMU authorities will hold on to their current policies while aiming to maintain the economicstability and growth outlook. For that reason, there exists a need to analyse the appropriate policies for stabilising the imbalances.

This dissertation focuses on the following research aims:Assess the likely impacts of Euro strengthening on EMU economy

Propose macroeconomic policies to anticipate the imbalances in the EMU economy fromEuro volatility.Evaluate cost and feasibility of implementing suggested policies.

1.1 Research Questions

1. How is the development of Euro against the dollar?a. What are the major factors behind the Euro appreciation? b. What are the systems used in determining exchange rates equilibrium level? b. Is the Euro overvalued?

2. What are the effects of Euro strengthening for the EMU economy in terms of macroeconomicobjectives?

a. How does macroeconomic data (inflation, interest rate, money supply, trade balance,Gross Domestic Product) signals the imbalances caused by Euro strengthening? b. What are the macroeconomic issues as the result of Euro strengthening?

3. What are the policies to adjust macroeconomic issues caused by Euro strengthening?a. What are the cost and feasibility of the suggested policies? b. Which is the best possible policy?

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1.2 Significance of Research

Real exchange rate appreciation can raise uncertainty about future values of exchange rate(Grier, 2005, p4). The knowledge of a nation currency determines the money related decision

making. The decision of the citizens in raising their money on investment and savingsdetermines the flow of the growth of GDP, aggregate demand, and prices, which consequentlyaffect the way authorities construct their economic policies.

For domestic EMU economy, decision makers are eager to see the continuation of Eurodevelopment. This research tries to clarify the current EMU economy state in association withEuro currency performance. What effect does a strong Euro have in regard to the EMUeconomy? Which best macroeconomic policy should the ECB apply to adjust the imbalances?This research intends to contribute knowledge to the decision makers in the field of business and policy making.

1.3. Methodology

There are three methods utilized in this dissertation. First, literature reviews in the area of exchange rate related to macroeconomic issues, the theories of exchange rate determination, andthe EMU macroeconomic policies. Second, detailed study on economic indicators data wascompiled to generate charts and statistical arguments. This economic data allows the author to

arise genuine analysis on the Euro exchange rate performance and its relativity to EMU. Third,simulations of policies transmission mechanisms are constructed to assess the cost and feasibilityof such policies (see Chart.1).

1.4. Dissertation Framework

The framework of this research is organised into six parts. First part discusses the research aimsand explains the research aims, methodology, framework, and limitation. Second part introducesthe Euro and EMU economy by focusing on the main factors behind the Euro appreciation trend.

Third part explains macroeconomic factors to be considered in relation to the problem. Next , theeffects of Euro strengthening to EMU economy are analysed. The main contribution lies inthe

following section which researches possible macroeconomic policies to anticipate/adjust theimbalance caused by Euro strengthening by assessing of cost and feasibility of implementingsuch policies. The recommendations to EMU authorities are integrated in this section.The final

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section presents conclusions of overall recommendation to adjust macroeconomic imbalancescaused by Euro strengthening and the summary of overall findings.

1.5. Limitation

In compiling sources of literatures and statistical data, the author is challenged through variouslimitations in the context of this dissertation. The main purpose is to stay in accordance with theresearch aims and objectives. Thus, the following explains the limitation that has been set.

data availability and sample population : in the early research, author desired toresearch the development of Euro against the US dollar, UK pound sterling, andJapanese yen. Most reviews and previous researches on macroeconomic issues and policies are mostly focused on the development of the Euro against the US dollar. Thus,this research concentrates on EMU (not EU) to characterise the countries that adopt theEuro as single currency.

time period for statistical data and literature reviews : to avoid ambiguity in referring tostatistics of economic data, data collected for this research is restricted to Euro Zone andUS economic indicators released between January 1999 and December 2007. But, notlimitation applied on the time period on literature reviews.

category of proposed solution : due to the number of policies exist, macroeconomic policies presented in this dissertation are limited to EMU main policies to adjust issues presented in section 4. problem solving target : the policies presented here are not aiming only adjusting thecurrent Euro value, but also, it focuses on the macroeconomic issues that need to befixed, although in the suggestions may include approaches to adjust the pace anddirection of exchange rate.analysis presentation : the Euro exchange rate value are presented in terms of EUR/USD, which means one Euro represent that amount of dollar. Analysis made are based on fundamental analysis and technical analysis from statistical data. Thus, marketresponds and institutional speeches are avoided.

In conducting this research, there are limitation faced by authors which resulting adjustmentto the contents. The credibility of data are varies due to the unpredictable market response.Therefore the theory is not easily modeled because of the complication above and the issuesare overly extensive.

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Source: Author

THE IMPACT OF EURO STRENGTHENING TO THE EMU ECONOMY: A REVIEW

Chart 1 Detailed Methodology

Identification of Research Aims

Literature Reviews

on the euro and EMUeconomy, exchangerate theories, c urrent

macroeconomic issuesin the EMU, and

macroeconomic policies

Hyphothesis 1

Euro appreciation iscaused by internal

and external factorsof EMU

Hyphothesis 2

Economic dataexplains the

relationship of exchange rate

and macroeconomicissues

Hyphothesis 3

Identification of euro

effects limits thepossible policies to

adjustmacroeconomic

issues caused byeuro s trengthening

Statistic and Data Analysis

Simulations of Policies Transmission Mechanisms

Summarise Analysis and Conclusion

Generate Further Research Question

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2. INTRODUCTION

The Euro has been appreciating by over 23 percent since the end of December 2005. It reachedits all-time low at $ 0.8252 in October 2000 (ECB) (see Chart 2). The trend seems to havecontinued since the Euro is still seen hovering around its highest point $1.45 $1.47 (write thesource of this bit of data) by the end of 2007.

Currency fluctuation in the financial market is often caused by short-term movements to satisfythe market expectation. It is when the market psychologically looks for further gains in thecurrency, it becomes the fuel for the continued rise of the Euro; hence the cause of rise in theEuro is regarded as a market sentiment. However, behind the market sentiment there has to existunderlying fundamental reasons. Some major events have contributed to the prolongedappreciation of the Euro. First is the improvement within the Europe, real interest rate

Chart 2Euro-dollar DevelopmentDecember 2005 - January 2008

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differential between EMU and US, the economy slowdown in US, and the emergence of Asiancountries.

2.1. Integration economy and monetary in Europe

De Grauwe (2005, p28) emphasized that integration in Europe would benefit an expansion of trade by 20 to 40 percent. Countries within the Euro account for 16 percent of the world GDPwhich is highly competitive compared to the 22 percent share of the US, and Euro countriesaccount for 19 percent of the world trade which is 4 percent higher than the US (Frisch, 2003).The positive views of the EMU economy are enhanced by the following arguments: 1) Differing productivity developments in the U.S. and in Europe (Corsetti and Pesenti, 2000); 2) Prosperouseconomic view; and 3) Framing of market beliefs (De Grauwe, 2005).

The Single European Act in 1986 brought about the next stage of European economicintegration which was followed with the accession of the single currency Euro on January 1999to realize the monetary union within Europe. The creation of the ECB and of the Eurosystemaccording to R. Mundell (1998) transformed the power configuration of the internationalmonetary system. The intra Euro has benefited the economy in several aspects: (1) tradeexpansion, (2) economies of scale, (3) productivity growth, (4) attracting FDI inflow, and manyothers (Barrell and Choy, 2003, p19). The intra-Euro area trade has increased around five to ten percent boosted by the single currency (Baldwin, 2005).

This integration and the benefits have given growth in competitiveness for Europe againstUnited States and other emerging Asian countries. According to CIA world fact book, EU population reached almost half a billion people 490,426,060 people in July 2007 which isonly around seven percent of the worlds population 6,602,224,175 people in July 2007 competing with India and China.

The benefits gained by the EU from the integration has allowed the Euro to appreciate; positiveoutcomes have built the economy stronger, encouraged market to build confidence on Eurocurrency and concurrently, accelerate the appreciation of Euro currency.

2.2. Deterioration of US economy

The rise of Euro has been focused mostly on Euro dollar exchange rate while the Euro has alsomade significant adavnces against the pound sterling and yen. Many arguments have tried to

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relate the rise of Euro exchange rate to the deterioration of US economy, but not necessarily tothe robust UK economy or the sluggish Japanese economy. Clearly, market perspectiveindicates that weak dollar plays the important role.

Since early 2006, there has been a slow down of US growth, whereas Euro Zone growth hastended to accelerate. Bizimana (2008) pointed out that the imbalances which have accumulatedin the US economy: the property bubble, swelling household debt levels, the current accountdeficit, etc., has resulted in lower growth outlook. The higher differential between the EuroZone and the US in area of growth, demand and capital flow, the higher the Euro will appreciate(Corsetti, n.d.).

Ben Bernanke, President of the US Federal Reserve, admitted the countrys slow growth is partly

stimulated by the crisis in US housing bubble and the fall in labor market. The high inflation inthe US was stated due to exceptional increase in oil prices and food prices (Crutsinger, 2007).

2.3. Real Interest Rate Differentials

According to Harvey (2006), Uncovered Interest Rate Parity Theory (IRP) is described asinterest-bearing assets through out the world must be identical once expected exchange ratemovements are taken into account (p3). Copeland (1989) explains that uncovered IRPdisregards the differential between domestic and international interest rate (p86).

Asymmetric economic development between the EMU and the US has naturally led to differentmonetary policy approaches. The EMUs recovering economic condition since the end of 2005allows the ECB to raise interest rate to a high point of 4 percent. In contrast, the US financialcrisis required expanding monetary action by rate cut to 4.25 percent (see Chart 3). A recentstudy (Lien, 2008) indicated that the damage of the US financial condition is enhanced bymarket prediction of Federal rate cuts that will continue for 50-100 basis points further during2008.

Since mid 2002, long term interest rate differential between the Euro Zone and the US has beennegative - ranging from 0.25 to 2.5 percent. Based on Uncovered IRP that the nominal interestrate differential is equal to the expected decline in the exchange rate (Arestis et al., 2001).Byrne and Derbin (2003) confirmed that except under conditions of massive intervention bycentral banks, interest rate parity gives a pretty reliable explanation of the difference in nominal

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interest rates and the spot and forward exchange rates. Thus, this confirms the Euroappreciation trend was signaled by the negative differential and expected changes in futureinterest rate.

0

1

2

3

4

5

6

Q1

2005

Q2

2005

Q3

2005

Q4

2005

Q1

2006

Q2

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Q3

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Q4

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Q1

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Q2

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Q3

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Q4

2007

Chart 3EMU vs. US Interest Rateend o f quarter value

ECB Fed

Source: ECB statis tics, Federal Reserve Bank of New York

2.4. Emerging Asian Countries

After the financial crisis in 1998/1999, emerging Asian countries like China, India, and Koreadeveloped their exchange rate policy towards deeper regional cooperation. They have been practicing tight competitiveness to raise their economy even further. They have departed from poor countries to transform into countries that have developed at a rapid pace (Suttle andFernandez, 2005). For example, China improved its real GDP by 9.7 percent annually, whichcatapulted its economic growth by over 11 times, and raised its world rank to 3rd from 27th

(Elwell, 2007). Another country that attracts the world attention is India. India has real GDPgrowth rate of average 7.8 percent annually, and by 2006, Indias economy in terms of PPP roseto the fifth largest. These countries are increasingly important for EMU as major trading

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partners; therefore, positive developments in emerging Asia has indirect contribution to EMU(ECB, 2005, Schiff, 2006).

0

2

4

6

8

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Euro Zone US China India World

Chart 4World Real GDP Growthper cen t, year over year

2005 2006 2007

No te: World GDP data are cal culated based on market exchange rate.Source: The World Bank, US Bureau o f Eco nomic Analysis, IMF, ECB.

The four main reasons above lie as the primary background of EMU economic changes that have

caused the appreciation trend for the Euro. Exchange rate volatility contributes continuously tocause changes in economy which are described in the economic indicators.

3. RELATIONSHIP OF EURO AND THE EMU ECONOMY

In order to comprehend the basic arguments of the Euro appreciation vs. stability for macroeconomic issues related to exchange rates, it is useful to briefly understand themacroeconomic elements related to four major macroeconomic objectives and their relationship

to exchange rate in general. These objectives are (i) full employment, (ii) price stability, (iii) ahigh, but sustainable, rate of economic growth, and (iv) keeping the Balance of Payments inequilibrium. Changes caused by Euro strengthening can be identified early by evaluating aspectsthat determine the stability of aforementioned objectives. Changes in aspects such as inflation,money supply, trade balance, and GDP provide a foundation for forecasting the EU economy

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growth, and also indicate whether the current economic policies are resilient with thefundamentals or the need exists to adjust such policies.

The aim of this section is to provide a basic understanding for the relationship of exchange rate

and significant economic elements. The discussion is strictly limited to the main elements thatsignal the changes in EU macroeconomic objectives.

3.1. Inflation

Inflation negatively affects the currencies marginal ability to buy a set of goods and services.Increase in inflation rate decreases the purchasing power of domestic currency, but whencombined with appreciation of exchange rate, this gives short-term indirect improvement of domestic PPP through lessened import inflation. An example case is that a high Euro lowers theimport inflation of high oil price on EMU. "Price stability is defined as a year-on-year increasein the Harmonised Index of Consumer Prices (HICP) for the Euro area of below 2 percent."(ECB). Euro areas HICP, which reflects Euro Zone price stability, showed inability to contain below 2 percent inflation after May 2000. HICP climbed over 3 percent for the last 2 months of 2007. Those are the same periods when the Euro was seen to appreciate and also reached an all-time high at the end of 2007 in the process. Another argument proposed is that the decision of the ECB to not reduce interest rates has given more room for Euro and inflation to appreciate.This shows that a strong Euro contributes to the inflationary pressures within the Euro Zone.

3.2. Interest rate

Interest rate rise acts as a booster when economy needs to increase output and promote growth.In contrast, appreciation of exchange rate gives downward pressure to interest rate. Interest rateand exchange rate has a linear link. A rise in interest rate affects the supply and demand of exchange rate and causes appreciation in exchange rate. Euro zone interest rate has been plummeting since the inception of Euro to 2 percent May 2003 and increasing to 4 percent bymid 2007. For growth reasons, the ECB interest rate rise has not only helped EMU to recover itseconomy strength, but has also caused the Euro to appreciate further. However, post June 2007,the Euro appreciation could be linked to Federal Reserve rate cut, thus applying pressure uponthe ECB to lower interest rates.

3.3. Money Supply

According to Herberner (1999), the ECB conducts its monetary policy through a Keynesianapproach. In this approach, rise in money supply leads to fall in interest rate and exchange rate.

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Euro Zone M3 money supply has grown in a rate above 10 percent which is above the ECBexpected rate of 4.5 percent (Neumann, 2003, p13). A larger money supply reduces the purchasing power and exerts a depreciative pressure upon the Euro; however, this condition alsocauses inflationary pressure which further causes interest rate rise.

3.4. Trade Balance

Trade balance refers to the difference between the (Euro) value of goods and services soldabroad and the (Euro) value of goods and services purchased abroad (Makin, 2000). Balance of trade is only concerned with the performance of export and import of a nation. A nationexperiences a trade deficit when it has a higher demand to import than to export goods. Theincrease in import will lower the demand for domestic currency, thus exchange rate willdepreciate (Porter, 1998, p5). On the other hand, exchange rate appreciation increases the purchasing power of the currency and thus initiates higher import, but leads to a fall in demandfor exports. The Euro Zones export has been declining around 2 percent in the last few monthsof 2007 due to the emergence of a strong Euro. The high value of Euro corresponded to theincrease in imports and has caused imbalances; a deficit of 2.1 billion Euro was posted onDecember 2007 for the first time in more than a year. However, Makins (2000) study concludedthat there is little evidence of exchange rate level as the determinants of trade balance.

3.5. Gross Domestic Product

GDP represent the total output value of income and expenditure terms of prices actually paid(Rugmann, 2006). GDP component include demand, output, consumption, investment, andexternal balance (export and import). In the short-term, high exchange rate has positiverelationship with GDP, because consumption is buoyed by cheaper price due to theimprovement of purchasing power. But in a longer term, strong currency causes prices to riseand price stability upward risk. A strong Euro pushed the European Commission for cuts in itsforecasts for annual economic growth that is already loaded with high oil price, economicdeterioration in the US, and higher forecast in borrowing costs.

Is the Euro overvalued?

Economic indicators have shown that a higher Euro does not necessarily reflect a healthyeconomic condition. The abovementioned conditions show that strong Euro causes disparity inthe components of inflation, monetary policy, balance of trade, and growth and thus, suggests the

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Euro is overvalued. All of the arguments above point out the relationship of exchange rate andPurchasing Power Parity (PPP). Arestis (2001) suggested two appropriate benchmarking inorder to have the correct value of the Euro which accurately corresponds to trade balance andPPP.

In an open economy like EMU, the law of one price states that two identical goods must have thesame price when translated into a common currency. In his book, Copeland (1989a, p74)suggests that based on the assumption of law of one price, PPP states the differences in inflationrates between two countries will be offset by the changes in countries exchange rates. Cato(2007) suggests the relation of real exchange rate and Purchasing Power Parity theory todetermine whether a currency is overvalued, consequently partly ignoring the nominal exchangerate. For example, if 1 Euro equals to 1.4 dollar, the nominal of 1 dollar equals to 0.1234 Euro.

However, if it requires 1 Euro to buy Big Mac in United States, the real exchange rate shows thatit requires more than 1.4 dollar for a Big Mac in Europe (see Table 1).

The Big Mac index translates PPP in terms of McDonalds product to show the degree of acurrency overvaluation or under valuation relative to the dollar (Economist.com). According tothe Big Mac Index, Euro is trading above its supposed real level by 22 percent. In his study,Bizimana (2008) concluded that by using the PPP approach, the Euro equilibrium range is 1.15to 1.25 per dollar (see Chart 5). This overvaluation is due to factors such as lack of response of

time and short-term capital inflow (Porter, 1998, p5).

Based on the Big Mac index and PPP calculation of Bizmana, the condition of Euro above 1.25 per dollar causes imbalances in the economy and thus, requires adjustment to bring the currentlevel to the appropriate equilibrium.

In order to understand the reasons behind Euro appreciation and the nature of the imbalance thatmight or have arisen caused by Euro, it is absolutely necessary to introduce the effects whicharise from appreciation.

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4. THE EFFECTS OF EURO STRENGTHENING TO EMU ECONOMY

The preceding sections have dealt with presenting the grounds for Euro strengthening andthe macroeconomic elements that build strings necessary to identify imbalances. The Euroarea fundamentals do not necessarily reflect the state of its economy. Instability in areas of export, price, and growth signal that the Euro strengthening has marked its impact. Thissection is represented to show the channel of Euro strengthening effect transmitted tomacroeconomic factors.

A high value currency weakens the competitiveness of a nations goods in the internationalmarket. Since demand increases when price level decreases, the high exchange rate distributeshigher price level, and potentially lowers the foreign demand. The impact of euro strengthening

to prices and inflation are explained in the following discussions.

4.1 Shift in Demand

In the last quarter of 2007, Euro area GDP growth decelerated to 2.2 percent compare to the 3.1the same quarter previous year. These GDP figures represent changes in EMU output, demandand trade balance. Euro area export growth decline to 0.6 percent (Quarter 4, 2007) from 3.3 percent (Quarter 4, 2006). The theory of supply and demand shows that demand declines as price increases. Thus, strong Euro leads to lower output (See Chart 6).

Chart 6 represents aggregate demand and aggregate supply curves of EMU and US. The demandcurve indicates that demand declines as price increases. The supply curve indicates that supplyincreases as price increases. A strong Euro leads to expensive exports and cheaper imports.It causes EMU-made products to be less attractive than its major opponent the US. As a result,consumers shift their demand to a lower cheaper currency the dollar thus causing thedemand of output curve in US to shift upward.

Export represents the total of foreign demand of EMUs products. Since, the EMUs exportsamount to over 20 percent of its GDP, this foreign demand has been in support of EMU growth.Thus a decline in export directly affects EMU growth outlook.

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Chart 6 : Demand Shift in EMU and US________________________________________________________________

__

EMUPrice

DemandSupply

Output

S

D

US

Demand

Supply

Price

Output

D

Supposed wage and labor mobility are constant, thus the adjustment for this imbalances is solelyon the price decrease, because supplier would produce more when cost is lower. To summarise,a strong Euro delivers high prices which leads to lower demand and output in EMU.

Inflation Risk Rising

In the last quarter of 2007, Euro Zone HICP is seen to increase sharply from 1.7 percent to 3.1 percent, where concurrently the Euro appreciated by 12 percent (1.3359 1.4966).Theoretically, demand shift causes prices and output shift in the same direction. But, recentevents of increasing world oil price and food price has created an inflationary pressure within theEuro area. Only in 12 months of 2007 itself, the crude oil price increased from $49.90 per barrelto $97.85 per barrel (Nymex). This is called import inflation inflation caused by domesticconsumption of foreign goods.

Although strong euro causes higher price of EMU goods, theoretically, it creates deflationary pressure on prices. Since EMU inflation has increase over ECBs annual target, this offsets thedeflationary pressure on exchange rate. Therefore, ECB would prefer to maintain the value of Euro at the current level otherwise lower Euro causes inflationary pressure.

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Chart 7: Euro Area Indices of Consumer PricesAnnual Rate of Change

1

1.5

2

2.5

3

3.5

4

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

Oct-06

Jan-07

Apr-07

Jul-07

Oct-07

%

HICP

ECB target

Source: ECB statistics, Eurostat

The aforementioned contradiction challenge authorities to create a policy to contain both

exchange rate stability and inflation. Grier (2005) found strong evidence that real exchange rateappreciation can be costly due to uncertainty about the future. In this case, uncertainty the futurevalue of exchange rate and the type of changes in future polices. Moreover, Griers hypotheseson developing countries show that increased real exchange rate uncertainty significantly lowersoutput growth and growth outlook. Consequently, authorities main concern would fall on the policy to bring inflation lower and demand shift to equilibrium. Demand-side policies will bediscussed further in the next section.

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5. POLICIES TO ADJUST MACROECONOMIC ISSUES CAUSED BY EURO

STREGHTENING

Although the above imbalances which appear in the Euro Zones economy are not yet alarming,Mishkin (1998, p24) agrees that authorities should not wait for apparent signals of imbalances because it would be too late to handle imbalances prudently. Considering the possibility that thedeterioration of US economy may not hit its lowest point anytime soon, the Federal Reserve willmost likely start raising interest rate while at the same time the ECB will start lowering it. Thiswill give a boost to US economy, improvement in US current account, and stronger currency.Even worse, the trend could be carried over to the following year. Thus, it is wise for the EMUauthorities to consider a way to arrest the march of the relentlessly appreciating Euro with a

suitable policy.

There are many macroeconomic policies that can be adapted to adjust economic imbalances;however, this dissertation selectively focuses with only those that react directly with exchangerate, namely: monetary policy, fiscal policy, exchange rate policy, and sterilised intervention.These policies are meant not strictly to prevent euro from appreciating but also to focus on thefluctuations of macroeconomic elements caused by euro strengthening. Each policy options will be discussed related to its cost and feasibility in EMU condition.

Grier (2005) argued that without policy intervention, the real exchange rate appreciation can potentially create economy costs. The category of macroeconomic policy in this section is based on the following assumption. Exchange rate policy refers to the arrangement of exchangerate management. Exchange rate policy is not exclusively presented because exchange rate policy can be a monetary policy, fiscal policy or a mix of both. Exchange rate policy can alsorefer to the exchange rate regime chosen by a country. The EMU is operating in an openeconomy and is adopting a flexible exchange rate. Because it is considered unfeasible for theEMU to change its exchange rate regime, thus, the analysis is not presented. Accordingly, thefollowing analysis and discussion limits the use of theory in the area of aforementionedcharacteristics of the EMU economy.

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5.1 Monetary Policy

5.1.1 Expansionary Monetary Policy

Monetary policy refers to the manipulation of money supply and interest rate to influenceaggregate demand, unemployment and prices to the desired direction (Friedman, 2004).Monetary policy can be expansionary or contractionary. Both systems influence exchange rateindirectly in opposite directions. Chart 8 shows how expansionary monetary policy lowersmoney supply and increases interest rate which dampens the demand and value of exchange rate.Moreover, there will be improvement in trade balance which promotes growth and prices.

Chart 8 : Expansionary Monetary Policy Mechanism ______________________________________________________________________

D foreign asset Investment

Saving Interest Rate

Money Supply Aggregate

Demand

Exports

Imports Exchange Rate

D for foreign

asset

GDP

Prices

Source: Slomand and Hinde (2007, p647)

In order to adjust the imbalances caused by Euro strengthening, the ECB should react byexpanding M3 and no longer put interest rate on hold (Breuss, 2002, p11). In a flexibleexchange rate regime as in the EMU, the transmission mechanism in Chart 8 affects the expectedrate of return on Euro deposits. Consequently, demand for Euro will be lower and the short-runeffect would be the Euro depreciation. This will bring Euro zone balance of payment toequilibrium. This is the transmission mechanism of expansionary monetary policy.

5.1.2 EMU monetary policy

EMU monetary policy is conducted by the ECB. The ECB plays a role as an independent bodyfrom the government. The primary objective of the ECB which is mandated in the Maastricht

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Treaty (1972) is price stability and other objectives to be pursued if not interfering with pricestability. However, in practice, the ECB has been criticised to only focus on price stability of annual increase in HICP of less than 2 percent (ECB). Svensson (2000) argued that thisstatement is ambiguous and asymmetric, while in practice, the Eurosystem targets on 1.5 percentinflation with tolerance interval of plus/minus 1 percent. Moreover, Svensson (1998), Mishkinand Schmidt (2001), and Breuss (2002) claimed that it is possible for the ECB to not onlystabilise inflation but also to stabilise output. A contrasting argument was given by Sibert(n.d.) that given multiple objectives, central banks credibility is at risk because the higher flexibility in either inflation targeting or exchange rate targeting, the lower the effectiveness of future monetary policy.

5.1.3 Effectiveness of Monetary Policy

In his work The Role of Monetary Policy (1968), Friedman compared four types of targeting bydiscussing their strength and weaknesses. These basic types are: 1) exchange-rate targeting; 2)monetary targeting; 3) inflation targeting; and 4) monetary policy with an explicit goal, but notan explicit nominal anchor.He recommended monetary targeting which was considered less riskyto achieve price stability.In a more recent study, Svensson (2008) and Friedman agreed on theeffectiveness of inflation targeting to maintain price stability based on the evidence provided in21 countries.

Mishkins (1998) and Svenssons (2007) studies analysed this theory on the sample of countrieswho conducts inflation targeting. The result confirmed that success stories showed inflationtargeting is an effective means of monetary policy.

5.1.4 The weaknesses of monetary policy

Classic weakness of monetary policy is that it cannot target both exchange rate stability andstable inflation. By bringing down the high value of Euro, the ECB is adjusting the external

value of Euro; thus, it costs the EMU with imported inflation which leads to increase in domesticinflation (Sibert, n.d). Conversely, as discussed in section 3, increasing interest rate is one of theinstruments to bring down inflation. Suppose for example, a strong Euro holds inflation.However, to bring Euro to equilibrium, the ECB monetary policy includes lowering the interestrate. Low interest rate leads to lower investment and output, which if accompanied with lower Euro will raise inflation. This illustration leads us to conclusion that interest rate influence on

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exchange rate is in conflict with providing low and stable inflation. So realistically, the ECB canaim at only a single target.

Another limitation is that monetary policy effect on exchange rate only works short term; thus itcannot (directly) influence output or employment (Bergo, 2002). However, over some time, the price level will go up proportionately to the money supply (Rashid, n.d.,p7). De Grauwe (2005, p34) noted that price has to decline to restore output to its initial level. If ceteris paribus, the costof implementing such a policy would amount toexchange rate overshooting. It is when Eurocontinuously depreciated over time until it reached a lower value than before the money supplyincrease (Cavallo, et al., 2002).

5.1.5 Recommendation to the ECB

Craig and Humpage (2001) clearly stated that only when the disturbance that initiates thecentral banks response is domestic in origin and monetary in nature, can monetary policyachieve both price and exchange-rate stability. Unfortunately, this is not the case for the Eurostrengthening. This condition points out the unfeasibility of expansionary monetary policy toadjust the Euro. The contradiction is too costly for ECB to jeopardise the current stableinflation. The logic is that by lowering interest rate, the ECB would successfully depreciateEuro; however, this policy only influences exchange rate temporary while interest rate has beenadjusted for some medium-term, thus the future disturbances to price stability are moresignificant.

5.2. Discretionary Fiscal Policy

5.2.1. Contractionary Fiscal Policy

Discretionary fiscal policy refers to control of fiscal budget through spending and taxation policyto affect aggregate demand (Sloman & Hinde, 2007, p683). The method includes expanding or contracting the fiscal budget so that factors of aggregate demand are increased or decreased tomaintain equilibrium. Aggregrate demand (AD) is composed by the total spending onconsumption, investment, government spending, and export minus import. Thus, when highexchange rate negatively affects aggregate demand, price stability, and GDP, a decrease ingovernment spending will directly affect the aggregate demand. Chart 9 represents themechanism of contractionary fiscal policy (the opposite method is expansionary fiscal policy) tocontain exchange rate appreciation.

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Chart 9 : Contractionary Fiscal Policy Mechanism

____________________________________________________________________

Source: Author

The above chart shows two transmission channel of how fiscal policy affects exchange rate.Firstly, fiscal is contracted by lowering government spending. This leads less borrowing ininternational market needed to finance budget deficit which leads to lower interest rate. Suchinterest rate differential would increase the demand for foreign assets and lower the demand for

Euro exchange rate, thus depreciate the exchange rate. The second channel is through thedampening of goods market by taxation. Increase in taxation will reduce income andconsumption and drive down investment. Demand is deteriorated, but in the short-run, fiscal policy does not affect output. Therefore, aggregate demand would fall and exchange rate woulddepreciate.

5.2.2 EMU Fiscal Policy

EMU fiscal objectives are stated in the Maastricht Treaty in 1992 and in the Pact of Stability andGrowth. The fiscal disciplines is to maintain budget deficit less than 3% of GDP and public debtless than 60% of GDP (De Grauwe, 2005). For the past 2 years, Euro area budget deficit has been improving from 70.19 percent to 66.4 percent. Fiscal improvement is due to the positiveimpact of Euro appreciation that lifts the economy state of some EMU countries.

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5.2.3 Effectiveness of Fiscal Policy

Auerbachs latest work (2005) suggested that fiscal policy has effective direct effect on

consumption, investment, and government spending and indirect effect on output. However, heconcluded that the success rate of implementing fiscal policy remains a question mark.

5.2.4 Weaknesses of Fiscal Policy

De Grauwe (2005, p29) stated that by changing taxes and spending, the authorities can createlarge assymetrics shocks. He argued that this is because taxation and spending in EMUcountries sum up to 50 percent of GDP. Therefore, the sensitivity to the EMUs GDP coulddirectly cause lower growth.

The weak point of this mechanism is the causal of capital outflow. The EMU preferablyencourages capital inflow which in turns will promote growth. However, such capital outflow isnecessary in this policy to depreciate the exchange rate and shift demand into domestic production. This would increase deflationary pressure on price and improve balance of trade.Thus, effect of fiscal contraction is entirely dependant on exchange rate and inflation. If this policy is adopted, the EMU will have to let capital outflow to stabilise the high Euro and containinflation.

5.2.5. Recommendation to EMU

Even though the transmission mechanism presented above focuses mainly on exchange rate and price stability, perfect capital mobility allows complete capital outflow and so fiscal contractionis ineffective (Hemming, 2002, p6). Unless the EMU prefers exchange rate stability more thancapital outflow, then, this policy is not suitable. Bruneau and de Bandt (1999), Aaerle et al.(2001), and Perotti (2002) estimate that fiscal shocks in EU area and other advanced countrieshave only short-run response or statistically insignificant (Hemming, 2002, p22).

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5.3. Sterilised Intervention Policy

5.3.1 Sterilised Intervention Policy

Foreign exchange intervention is the practice of monetary authorities buying and sellingcurrency in the foreign exchange market to influence exchange rates (Neely, 2005, p3). Buying(selling) actions directly decreases (increases) the total amount of home currency in the market,which affects domestic money supply.

Below is an illustration of the ECB intervention for Euro appreciation based on classification of effective intervention:

1) Leaning against the wind (breaking/reversing the trend; WIND) : the ECBintervention aims to reverse the Euro appreciation trend to depreciation trend.

2) Smoothing exchange rate movements (dampening or slowing the trend;SMOOTH) : the ECB intervention aims to reduce the pace of Euro appreciation.The appreciation trend is still favorable for the ECB.

3) Leaning with the wind (WITH) : the ECB purchases Euro to cause moreappreciation after the intervention episode than before the intervention episode.

However, it is noted that most central banks intervene for the purpose of first and secondclassification, thus gert, & Komrek (2006, pp 8-9) suggested to drop the third classification because it simply indicates unsuccessful official intervention. As a side effect of foreignexchange interventions, it seems that on average, interventions combined with interest ratechanges tend to increase exchange rate volatility from 30 up to 60 days after the interventionstook place.

To distinguish intervention from ordinary domestic Open Market Operation, most central banks

sterilize their operation by buying and selling domestic bonds to reverse the money supplyeffect (Edison, 1993, p16). Hutchinson (2002) shared the same opinion for the operationeffectiveness, intervention should be sterilized from accommodating or reinforcing monetary base, interest rate, or other policy measures. It is now an independent instrument of stabilisation policy to target directly on exchange rate.

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5.3.2 EMU sterilised intervention policy

In the year 2000, the ECB conducted several sterilised interventions to reserve the eurodepreciation. ECB utilised the signaling approach of future central banks monetary policy.Frenkel et al. (2006) entailed that the ECB approach in conducting this policy is by signalingtheir future action in monetary policy.

In this research, no mandatory requirements were found on sterilised intervention such as in the previous policies. Thus, it is assumed that the ECB influenced exchange rate market until the point of the signaling approach is considered effective. This theory is based on assumption thatthe market may take current action by predicting the future.

5.3.3 Effectiveness of sterilised intervention policy

A large volume of literature has focused on the study of rate of success and effectiveness of sterilised intervention. Siklos and Weymark found that sterilised intervention operation has beenmore effective in emerging markets because of more volatile exchange market (2007, p3) andthe success rates are higher if sterilised intervention policy objective is aligned with domesticmonetary policy (2003, p26). In countries like the EMU, where inflation targeting is the primaryobjective of monetary policy, there is a risk of sterilised intervention conflict with inflationobjectives. Although the sterilised intervention, theoretically, offsets the effect of monetaryinstrument, there lies the risk of limited success creating rising exchange market pressure. Thus,to reduce significant unexpected effects of sterilised intervention, Sarno and Taylor (2001, p850)emphasized that intervention policies should be in line with the underlying stance of monetaryand fiscal policy, because if central banks prefers to correct intervention with another intervention, then the cumulative effect of intervention is nil (Fatum and Pedersen, 2007, p5).

5.3.3 Limitation of sterilised intervention policy

In contrary to the positive views of this policy, there are studies by Craig and Humpage (2001, p5) that point out ineffectiveness of this policy to reverse the direction of an exchange ratemovement and instead it had a tendency only to smooth the pace of appreciation or depreciation. When the ECB maintains an unchanged interbank rate it automatically offsets(or sterilizes) the impact of any exchange-market intervention on its monetary base (Craig &Humpage, 2001).

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Schmidt and Wollmershuser (2004, p21) pointed out that central banks could use this policy toinfluence exchange rate movements. But even the most-utilised technique the smoothing ;evidence of occurence in Japan is that the results were insignificant.

5.3.4 Recommendation to EMU

Previous studies have stronger arguments on the ineffectiveness of sterilised intervention policythan on its effectiveness. Previous studies investigating the ineffectiveness based on actualintervention policies of developed countries like Japan, US, and the EMU. The result is anagreement of the futility of this policy. Conversely, previous studies assessed the effectivenessof this policy by using different theoretical methods of calculation. Thus, the arguments for this policy effectiveness are mostly empirical analysis to proposed advice for further progress.

Edison (1993) surveyed various literature after 1982 and concluded that empirical evidencecould not confirm effectiveness of this policy.

Sterilised intervention policy is not recommended for EMU to expect medium-term or long-termresult on the Euro development. But if the EMU considers that the trend of the Euro isfavourable and only targets to slow the current Euro rate, smoothing technique of sterilisedintervention policy should be effective. But it is to be borne in mind, that this policy is onlymeant for short-term adjustment.

5.4. Recommendation to EMU

Each of three recommendations given above has its strengths and weaknesses. As a result,deciding on which best policy to adopt is not easy because each policy does not offer ideal resultfor EMU in adjusting imbalances. In 1960, Mundell-Flemming proposed a theory of ImpossibleTrinity (Pandey, n.d.). This theory stated that it is unfeasible for economy to achieve threefollowing objectives at the same time:

1. Stability in exchange rate2. Free capital movement3. independent monetary policy

Consequently, the EMU with an open current account also encounters this conflict. It can aim tostabilise the Euro and have capital flow move freely, but in the cost of forsaking interest rate as

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instrument to fight inflation. This conflict remains unavoidable when ECB tries to keepexchange rate and price stability intact.

Expansionary monetary policy is not favorable with the current EMU state. Although inflationlimit mandated in the Maastricht Treaty is below 2 percent, as discussed in section 5.1.2., ECBallows tolerance level of +/- 1 percent. Inflation level up to the end of 2007 is still in thetolerable band. For that reason, it is careless for EMU to jeopardise price stability by loweringinterest rate as stabilizing policy. But if the current inflation has reached over 3 percent, it is alsonot proper to increase interest rate to defer inflation pace because this will raise the Euro evenhigher. Accordingly, this policys conflict with price stability is inevitable for the Euro at thislevel.

Contractionary fiscal policy is not eminent in this research. Factors influenced by this policy arethose that EMU prefer to maintain stability. The transmission of this policy is not feasiblewithout interrupting current monetary policy and thus jeopardising price stability. In regard toits short-run effect, the implementation of fiscal policy proposed higher risk rate thansuccessful rate.

Svennson (2000) stated that the time required for policy to take effect since the implementation period can be an economic cost if no consideration is given to policy making. For instance, if monetary policy to affect inflation is implemented in 2007, it is foreseeable that this policycauses effect to certain elements immediately, but not to inflation. EMU can expect to seeimprovement in price stability at end of 2009. This limits the assessment of policy effectivenesson adjusting the economy. Svensson (2000) concluded that his study shows that monetary policy requires one year taking effect on output and two years on inflation.

For the above reasons, sterilised intervention policy is perceived to be direct and lesscomplicated to adjust the Euro and imbalances caused by it. Adopting this policy causes less probability for new imbalance to arise, thus less future disturbance to other economic elements.So, imbalances caused by Euro strengthening are expected to restore its equilibrium level byadjusting the main cause the Euro.

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6. CONCLUSION

This research has tried to investigate the impact of Euro strengthening to the EMU economy.

The result is that EMU authorities can influence the development of Euro by means of macroeconomic policies, namely: monetary policy, fiscal policy, and sterilised intervention policy. The feasibility of each policy depends on other economic determinants such as inflationlevel, budget deficit performance, and demand. Descriptive transmission mechanisms of such policies also suggest the cost and feasibility of these policies.

Aside from all the theories presented and the attempts to explain the relationship of Eurostrengthening and macroeconomic policies, these mechanisms presented works perfectly if

ceteris paribus. Unfortunately, this is not a perfect world. The fact that the EMU and the Eurooperates in open economy complicates not only the making of but also the coordination of the policy making itself. No one particular option of policies can solve the problem of Eurostrengthening without causing expected changes {and unexpected changes} in all other economic aspects. If this is the case, then policy making issue requires continuous assessmentand flexibility.

In respect to current EMU policy, sterilised intervention policy is perceived most suitable toadjust current Euro condition. However, the arguments lying here are too simple. Marketresponse and authorities forecasting approach are natural intervention in itself. Thus, theexploratory study to present the most effective policy to adjust Euro strengthening and its impactto EMU economy is inconclusive.

For further study, one can consider to present a large sample of other nations similar experienceand compare the result of their solution implementation. Next, it is possible to initiate testingwhether the samples solutions works on EMU. Finally, the transmission mechanisms of policies presented in this dissertation are too ingenuous to not include the real complication in the EMUeconomy. This dissertation rests these additional rooms for future work.

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Documents

The Impact of Euro Strengthening to the EMU Economy