Exchange Rates the Euro and the European Union

Exchange Rates the Euro and the European Union

The European Union

 It is a trading bloc of 28 countries who have come together to have;

 Free trade (Single European Market)

 Economic co-operation and political co-operation

Aims of the EU

 Free trade: no customs/import duties between member countries.

 Free movement: of capital (money) & labour (workers).

 Common currency: the euro is only used by 17 member states at present.

Economic advantages EU membership

1. Access to EU funds

EU countries have access to EU funds, which will help develop their economies further.

2. Access to larger markets

Companies operating in the EU will now have unrestricted access to the other EU member

states, thus boosting trade.

3. Mobility of labour

Labour can now move to other EU member states to seek employment and to seek further education opportunities.

4. Location for inward investment

Membership of the EU results in these countries becoming more favourable destinations for inward investment.

5. Employment

With the increase in inward investment there will be a greater demand for labour.

6. Increased economic growth

Greater production will result in increased GNP within these countries.

7. Improved standards of living

With more jobs, higher incomes and greater spending the citizens should enjoy an improved standard of living.

8. Increased competition

Consumers should benefit as these economies become subject to increased competition, which may result in more competitive prices and/or improved quality of goods and services.

9. Tourism opportunities

Citizens of existing EU member states will, over time, become more informed of the new member states and this may boost the tourism industry in the new member states.

10. Human rights safeguarded

Being a member of the EU will help safeguard the human rights of citizens of these countries, some of which are developing democracies.

11. Economic stability

As a member of a large and important trading bloc, with membership of the euro possible,

economic stability of the new member states should be improved.

Implications of EU enlargement for Ireland

Economic & Monetary Union (EMU)

Single currency – The Euro.

Members of the EU

Advantages of the Euro

 No need to convert currency when trading with these countries, save money.

 Easier to compare prices.

 More employment due to US companies setting up in Ireland to have access to EU.

 ECB sets the interest rate – low at the moment.

Disadvantages of the Euro

 Ireland has no control over its interest rates.

 UK did not join – major trading partner.

 Increased competition as consumers can compare prices easily.

Economic effects of the UK introducing the euro

1. Exports prices stabilise.

Variations in the price of Irish exports to the UK due to currency fluctuations would no longer apply as both countries would now be using the same currency.

2. Import prices more certain.

If both countries were using the same currency the price of imports from the UK could not increase or decrease, due to changes in exchange rates.

3. Debt repayment.

More certainty would apply to the repayment of debt which was formerly denominated in sterling as variations in such repayments will not vary due to currency fluctuations.

4. Inflation.

The rate of inflation in Ireland would be less volatile as the inflationary/deflationary effects of currency changes on the price of UK goods bought in Ireland would be eliminated.

5. Tourism.

The Irish tourism industry would benefit as UK holiday makers coming to Ireland would no longer be required to change their sterling into the euro. A strong euro would no longer act as a disincentive to UK holidaymakers visiting Ireland.

6. Price comparisons

The use of the same currency in both countries would allow for price comparisons by consumers in theUK and Ireland.

Exam Question

2007 OL Q 5 (c)

You are given the following information about the Euro (€) to US dollar ($) exchange rate.

Year 1: €1 = $1.20 Year 2: €1 = $1.30

(i) State whether the euro has gone up or down in value relative to the dollar. Explain your answer.

Answer: The euro has gone up in value.

Explanation: It is now worth 10 cent more than in year 1.

Effects of the euro increasing in value relative to our trading partner’s currencies.

Effects on the Currents Account (Imports & Exports)

Effects on Irish exports

1. Exports will become dearer

The prices of Irish exports in foreign currencies will increase.

It will take more of a foreign currency to buy an Irish product.

2. Reduced demand/sales

More expensive Irish products may result in a reduced demand for Irish exports.

3. Reduced sales revenue

Reduced demand for Irish goods/services will lead to a fall in sales revenue and as a result possible job losses or even closure of the some Irish firms.

Effects on imports into Ireland

1. Imports cheaper

The prices of foreign imports in euro will decrease.

It will take less euro to buy a foreign product.

2. Increased imports

This may result in an increased demand for foreign imports into Ireland.

3. Decreased inflation

Lower prices may lead to a fall in the inflation rate.

Cheaper raw materials may result in lower costs of production.

Effects on the Capital Account

1. The real value of money invested abroad is greater:

May result in greater capital outflows.

2. Real value of money from abroad invested in Ireland is reduced:

May result in reduced capital inflows.

3. Irish borrowing abroad is more attractive.

May result in increased foreign borrowing.

4. Foreign investment in Ireland is less attractive.

May result in reduced foreign direct investment in Ireland.

Effects on employment within Ireland

1. Employment may decreases

With fewer exports to foreign markets, firms in the exporting sector will decline resulting in

unemployment. With reduced investment in Ireland there will be less demand for labour.

2. Employment may increase

If imports are mostly raw materials then the prices of the finished goods could fall leading to an increase in demand and job opportunities

Effects on citizens in the Republic shopping in Northern Ireland

1. There will be more cross border shopping

• Shoppers will now be able to get more value for their euro in NI and therefore more citizens may shop in Northern Ireland.

Economic effects of cross-border shopping on the Irish economy

1. Tax revenue falls

Less VAT / excise duties will be paid to the Irish government as they will be paid to the UK government instead.

2. Unemployment:

Closure of some businesses and resulting job losses in the republic, due to reduced spending.

3. Closure of businesses

Some businesses may become bankrupt due to decreased demand, sales and revenues and as a result may have to close down.

4. Increased imports into the Republic resulting in an adverse effect on the balance of

payments position / reduced circular flow of income within the country.

5. More competitive pricing

Retailers in the South may reduce prices in order to compete with retailers in Northern Ireland. This is good for Irish consumers but it may cause job losses as retailers may have to cut costs to make up for the reduction in price.

6. Taxation policy

The Irish government may consider reducing VAT in the Republic of Ireland to reduce the price difference between North and South.

7. Pressure to change government policy

Organisations such as the Irish Business and Employers Confederation (IBEC) will put pressure on the government to change economic policies so as to reduce costs in the retail sector.

Purchasing Power Parity Theory

In a free market, the exchange rate of a currency will settle at that level where the purchasing power of a single unit of the currency is the same, regardless of where it is spent.

So in theory if a burger costs 1.00 in the UK and 1.50 in Ireland then the exchange rate should be 1 pound = 1.50 euro. If not then burgers would be bought on one market and sold on the other until equilibrium is reached. However there have been criticism of the theory because;

• Not all markets have free trade as some countries engage in protectionism.
• It does not take into consideration distribution costs.
• Not all products are transferable.

The Big Mac Index is published by The Economist as an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. It "seeks to make exchange-rate theory a bit more digestible"

The index takes its name from the Big Mac, a hamburger sold at McDonald's restaurants.

The Big Mac index was introduced in The Economist in September 1986 by Pam Woodall as a semi-humorous illustration and has been published by that paper annually since then. The index also gave rise to the word burgernomics.

The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued.

For example:

1. the price of a Big Mac was $3.57 in the United States
2. the price of a Big Mac was £2.29 in the United Kingdom
3. the implied purchasing power parity was $1.56 to £1, that is $3.57/£2.29 = 1.56
4. this compares with an actual exchange rate of $2.00 to £1 at the time
5. [(2.00-1.56)/1.56]*100= +28%
6. the pound was thus overvalued against the dollar by 28%