Economic and Monetary Union

Most of the countries in Europe are participating in a bold economic experiment in which national currencies were replaced by a common currency (called the Euro) by 2002. In May 1998, decisions were made on which countries were eligible for participation in the European Monetary Union. A European Central Bank was created in 1998 that is charged with coordinating monetary policy for the EU. Since January 1, 1999, the Euro has been used for all foreign exchange operations in the participating countries. Euro banknotes and coins began to circulate on January 1, 2002 and completely replaced national currencies by July 1, 2002 (existing national currencies ceased to be legal tender in the participating countries on or before this date).
Supporters of the European Monetary Union argue that the introduction of a common currency will reduce transaction costs and increase the volume of trade among the participating countries. This results in larger gains from trade and increases the extent of competition in most product markets. Tourists will also benefit from the lower transaction costs associated with a single currency.
The introduction of a single European currency, however, also means that the participation countries will no longer be able to pursue independent monetary and fiscal policies. Monetary policy for the EU will be under the control of the European Central Bank. One of the major concerns about the success of the monetary union is whether this central bank will be able to maintain an independent policy of maintaining a low inflation target. While each country has some control over its own fiscal policy, the ability to engage in deficit spending is limited since the monetary union shares a common interest rate. Higher levels of government borrowing in one country raise interest rates in all participating countries. Countries that maintain deficits that exceed a specified value will be subject to sanctions. This may require countries to engage in procyclical fiscal policies during a recession (i.e., increasing taxes and/or reducing government spending or transfer payments to reduce a deficit). …