South-Western EconNews

Forget the Franc, Ditch the Drachma

Subject

Exchange Rates

Topic

International Finance

Key Words

Currency Union, Exchange Rates, Economic Growth

News Story

At the stroke of midnight on December 31, 2001 the euro becomes legal tender for 303 million people in 12 countries. Francs, drachmas, liras, pesetas and various other national currencies will virtually disappear. ATMs, postage stamps, parking tickets, the game of monopoly, as well as prices of every item sold in the participating countries will change. This extraordinary move will provide a host of benefits to Europeans, the most visible being the ability to avoid exchange bureaus when traveling form country to country. European planners are hoping that the adoption of the euro is a big step towards what Winston Churchill called, "A United States of Europe."

Approximately $600 billion in euro notes will debut January 1, 2002, making the euro the second most important currency in the world. Austria, Belgium, Finland, France, Germany, Greece, Ireland, Luxembourg, the Netherlands, Portugal, and Spain comprise the 12 European Union countries that have adopted the euro. Britain, Denmark and Sweden are the only three EU countries that opted out. Euro notes will come in 7 denominations, from 5 to 500 euros. Each euro is currently worth $.88.

Although the euro was introduced as a currency on January 1, 1999, its circulation was limited to electronic transactions and bank deposits. At that time, participating countries had to fix their exchange rates to the euro and surrender control of interest rates to the European Central Bank. In the three years that have elapsed, no major problems appeared and even though growth rates varied considerably, from a recession in Germany to a significant economic expansion in Ireland, none of the 12 countries opted out of the euro. Participating countries have signed a stability and growth pact that limits budget deficits and attempts to preserve the value of the euro. While there is concern that the adoption of a single currency can produce economic problems, the 12 euro countries are hopeful that the euro will provide a powerful economic punch to their economies.

(Updated January 15, 2002)

Questions

1.	Critics of the new currency argue that one of its initial effects is to raise prices. They argue that retailers will round prices upwards when converting their local currency to euros. How does a local retailer convert his/her prices into euros? Is there anything that will prevent a retailer from rounding his/her prices up?
2.	One of the hoped for benefits from a common currency is to reduce the variation in prices from country to country. For example, before the euro, the cost of a Big Mac varied by 75 percent, but with the euro prices are only expected to vary 37 percent. Explain why the elimination of fees for currency conversion will tend to reduce price variation for the same good between countries.
3.	What determines the value of the euro vis-á-vis the dollar?

Source

T.R. Reid, "W. Europe Ready for the Euro," The Washington Post, December 31, 2001.