Monetary policy Essay Example | Topics and Well Written Essays - 1000 words

Monetary policy - Essay Example The normal fluctuation rate dictated by ERM is + or – 15 percent. However, countries that are able to maintain very high degree of convergence to the Euro can negotiate narrow fluctuation band (range). For example, Danish fluctuation rate has been allowed a narrow range of + or – 2.25 percent because it was able to maintain excellent convergence to the euro. The main reason of controlled currency fluctuations is to minimize foreign currency risks caused by high and sudden currency value fluctuations. Stabilization of the national currency through pegging system helps to promote trade by minimizing trading barriers. Trade barriers (increase in currency exchange costs) result from sudden fluctuations in foreign currencies that may increase cost of doing international business. Pegging currencies in the euro zone was aimed at speeding up the adoption of single market. In the event that European Union member currency surpasses predetermined currency fluctuation range, the E uropean Central Bank and the central bank of that nation should intervene by fixing foreign exchange rates consistent to country’s economic needs. This is in a bid to ensure that the exchange rates are kept within the fluctuation range. The European Central Bank can advance short term loans to rectify currency fluctuations in the short run caused by instant speculative pressure. However, short term interventions by The European Central Bank can be suspended if interventions contradict with objectives and aims of both the European Central Bank and country’s central bank. Membership to EMR II is not mandatory but is a prerequisite foe any country, which wants to join the euro zone. No country will be admitted to euro zone until it participated in EMR II for at least two years with no severe tensions and devaluations. ii) Advantages and disadvantages of resulting from agreements with EU to Peg the Pound to the Euro and join the European Monetary Union a) Pegging the Pound to the Euro When a country is pegged to a euro, movement in the euro is followed by movement in the currency associated with it. There are some advantages associated with pegging the pound to the euro. First, the euro is becoming popular. Euro has become favorable international currency for most governments. Most countries outside the euro zone have already pegged their currencies to the euro and are enjoying financial stability. Euro provides shelter against unexpected drops in individual currencies. Bulgaria, Estonia, Lithuania, Bosnia, Herzegovina and Cape have not adopted the euro but have pegged their currencies to the euro. This makes the euro stronger and stable. Secondly, pegging pound to euro will reduce pounds’ fluctuations (shocks). Pound will gain strength and stability as euro gain strength. According to Ghosh et al (2002), pound will achieve more clarity, transparency and predictability if pegged to the euro. This is because currency pegging imposes necessary d iscipline when country is dealing with foreign exchange currencies. Third, pegging pound to euro helps to enhance pound’s credibility. Credibility will be achieved when pound is pegged to euro, which has lower and increasingly predictable rate of inflation. There are disadvantages associated with pegging pound to the euro. First, pound is likely to lose value when euro loses value. This is because changes in anchor currencies will affect associated