The Maastricht Treaty launched the European Monetary Union in the year 1992. The union comprised of two parts, which included the creation of euro the common currency and creation of the European Central Bank, which coordinates all monetary policies in the Eurozone. The treaty also created the rules for countries willing to join the union. The other element of the treaty was the national central banks of the 16 member countries. European Monetary Union creation has led to price stability and proper management of public finances (McKay Volz & Wolfinger 2011).The final phase of the single currency introduction was the fixing of the exchange parities of different countries forming the European monetary union. However, the introduction of the single currency has been filled with uncertainties leading to the balance of payment crisis in member states of the European Monetary Union. The aftermath of the global financial crisis led to the introduction of various fiscal and monetary policies in their effort to stimulate their economies. When a country has a large budget deficit, maintenance of a fixed rate of exchange is difficult leading to the ultimate balance of payment crisis (Kopits 2000). This can be used to explain the predicaments facing the European Union since they operate under a fixed exchange parity system.
There are various macroeconomic theories that have been used in the explanation of the balance of payment disequilibria crisis, and the correcting mechanism that can be used to facilitate correction of the crisis. For example, the Keynesian theory, monetary and structuralist theories have been used in explaining the corrective mechanism of resolving the balance of payment problems. These theories have been used in explaining different macroeconomic variables, which affect economic stability. For example, the macroeconomic variables include the prices, income, the general levels of employment and exchange level. Therefore, this study focuses on how the macroeconomic variables are used and explained in different theories in the correction of the balance of payment disequilibria.
The type of exchange rate system adopted by an economic is an essential determinant if the stability of the country balances of payment. For example, a country operating a flexible rate of exchange stands at a better position to correct the balance of payment disequilibrium as a compared to an economy with a fixed exchange rate system. When a country operates a fixed exchange rate system, increase in the external values of money appreciation of currency makes imports cheaper while the exports are made expensive (Lal 2007). This leads to the ultimate source of balance of payment disequilibria since exports are reduced while imports are increased. This has been characterized in the European Monetary Union members after the integration of the currency there has been a fixed exchange rate system leading to the difficulties of the countries in correcting their balance of payment.
Different economies have adopted various macroeconomic and monetary policies in stimulation of their economies. The policies in the European Monetary Union can be dividend in the view of individual countries as well as in the view of policies adopted by the. In addition, the policies adopted can further be divided into various macroeconomic theories such as monetary theory, Keynesian and structuralist theory. The monetary theory is based on the concept of controlling the supply of money in the economy such as reducing the supply of money in the economy through various monetary policies (Carlos Luis & Santiago 2008).
For example, different individual countries have used the monetary approaches in dealing with the financial crisis that have been the major contributor to the development of disequilibria in the balance of payment. Take for instance, the quantitative easing approach that has been used in various countries as a corrective measure to stimulate the economies. Quantitative easing approach is a monetary approach, which aims at increasing the money supply in the economy through printing of new currency by the government. Additional currency in the economy reduces the short-term interest rates hence inducing borrowing that will facilitate investments by the private sector. Reduction of the interest rates also affects the exchange rate in the individual countries hence facilitating the achievement of balance of payment (John 2010). Increased investments by the private sector lead to increased economic activities hence increased exports reducing deficits in the balance of payment.The monetary policies adopted in different countries also affect the general price levels in such countries. From the monetary theory, an increase in level of the money supply in the economy leads to inflationary tendencies, in the economy.
The main objective of creating European Monetary Union was to facilitate trade between the countries operating in the region ensuring macroeconomic stability of the countries. The union has been able to achieve various objectives although it has been met with various challenges such as the disequilibria in the balance of payment. The criteria of a good international monetary system, such as the one created by the European countries is to ensure sufficiency of liquidity. In addition, such a system should ensure smooth adjustments of the balance of payment when there is disequilibrium.
The domestic prices relative to the foreign prices can be used in explanation of the disequilibria in the balance of payment. These have been important in explaining the capital inflows and the consequential effect on the balance of payment. Various findings have established that the relative prices are exogenously determined and they adjust to the balance of payment disequilibria. When there is deficit in the balance of payment, in the economy the income level in such a country decreases, in response to the external deficits. This deficit may be amplified or reversed by the capital flows in and out such economies, affecting the speed with which adjustments take place. The level of export and imports in the countries is also dependent on the level of relative prices in the economy.
Different countries in the European Monetary union responded differently to the creation of the union and the consequential creation of common currency. For example, a country like Portugal has experienced a deep stagnation, while other like Spain have experienced significant boost. For example, the period between 1995 and 1999 the GDP of Portugal grew by 4.1 percent, while that of Spain grew by 3.3 percent. However, in the period of 1999 and 2007 the GDP rate of growth in Portugal declined by 1.4 percent, but Spain experienced a 3.6 increase in GDP (Garcimartin Rivas & Martinez 2010).
There has been a great variance in the balance of payment, where the balance of payment between the period of 1995 and 1998 prior to joining European Monetary Union Spain had a small surplus of 0.3 percent of GDP. Portugal had a deficit amounting to 7.6 percent of the GDP. However, Portugal deficit has increased on joining the European Monetary Union. This shows that the individual countries need to adopt different specific measures in dealing with disequilibrium, in their countries (Garcimartin Rivas & Martinez 2010).
There are various other policies that can be adopted by individual government and central banks in correction of balance of payment disequilibria. For example, the government through their central banks can deplete resources of their foreign currency, which will facilitate the correction of the balance of trade disequilibria. A common strategy that has been employed by the European Monetary Union is lending to their member countries in order to facilitate correction of the balance of payment disequilibria (Égert & Kierzenkowski 2009).
The union also provides financial support for structural reforms of their member countries to facilitate economic growth. For example, the precautionary assistance programs developed by the institution have been developed to facilitate medium term financial assistance. This lending is essential in facilitating economic growth and development, which will be essential in correction of the balance of payment disequilibria. Individual can also impose direct controls in their economies in order to restrict certain trades in their countries that contribute to balance of payment disequilibrium. The direct controls that can be used in these economies include quotas embargoes and curtailing of imports. This will facilitate individual countries achievement of balance of payment. (Cencini 2009)
The adoption of a common currency by the European Union has also led to a fixed like exchange system, which has been among the cause of the balance of payment problems in the member countries. Therefore, the European Union Central Bank should work with the member central bank in adopting an exchange rate that ensures incorporation of the changes in the global market. This will facilitate flexibility of the euro in the global trade hence increased trade. The fixed exchange rate system has led to decreased exports of the countries since the exports have become expensive while the imports are expensive causing the balance of payment disequilibria (Capeta 2004).The individual cooperation of the individual members’ central banks and the European Union central bank will facilitate depreciation of the euro used as the common currency in the region. This will lead to reduced prices of exports making the exports cheaper, which will in turn lead to increase in foreign demand of the products produced in the countries.
Depreciation of currency also causes an increase in the prices of imports, which will reduce imports demand and the total value of imports in the form of foreign currency falls. This leads to an improvement in the current account of a country hence correcting the balance of payment disequilibria problems.However, currency depreciation may not be effective in the short term as it may even cause the balance of trade to worsen after which it improves. This caused by the facts that demand in the short term is usually inelastic (Angel 2008). Therefore, even though the imports are cheaper the levels of quantity sold does not rise rapidly and even though the imports have become more expensive, their demand does not fall rapidly. This is illustrated by the J-curve phenomenon illustrated in the graph below.
Balance of payment
At the initial time T1, the balance of trade is deficit. If the European central bank and member states agree on a flexible system the market will react to this deficit where the euro will depreciate leading to an increase in the trade deficit, in the countries operating under the European Union. However, in the long run as indicated in the graph at period T2 and T3 the trade deficit is eliminated at period 3.
There are other policies, which are adopted by various governments through the central banks to improve and correct their balance of payment. Various monetary policies are applied in different economies depending on their suitability and functionality in such economies. For example, the tools of the money supply used in different economies, which include the bank rate policy, minimum reserve ratio and selective credit control can be used by the central bank in controlling the level of the money supply in the economy which in turn leads to correction of the balance of payment (Annalisa 2009). In correcting the balance of payment equilibria, the government can apply several fiscal policies. These policies include increasing government expenditure on structural changes in the economy such as infrastructure (Agley 2005). This stimulates investments by the private sector as it facilitates the growth of private investments. In addition, increased spending by the government increases the level of income in the country, hence raising the aggregate demand. As illustrated previously, the increase in demand will lead to an increase in price of product and inflation has been seen as a solution to the problem of balance of payment disequilibrium. The government can also impose heavy taxation on imports while reducing tax on exports (Solsten 2009). This will serve the purpose of discouraging imports and encouraging exports, which will lead to correction of the balance of payment in the country.
In conclusion, balance of payment in the European Union country members has been an issue, which has attracted the views of different economist as to suggestion on possible solutions. There have been various theories that have been put forward in explaining the cause and dies that can be taken in correction of the situation. For example, the Keynesian theory, monetary and structuralist theories have all been used in explaining possible remedies. Individual countries take some of the courses of actions while both individual and the European union through the central bank take some measures. These measures are being developed with the aim of stimulating the economies from the financial crisis, which led to the current economic problems being experienced.
Alberola, E. and López J. H. “Internal and external exchange rate equilibrium in a cointegration framework: an application to the Spanish peseta”, Spanish Economic Review, 2001, vol.3, n.1, 23-41.
Annalisa, R. October 01, 2009. The Origin of the Political Economy of Money.Review of Political Economy, 11, 4, 443
A country and/or international organization faced with a big disequilibrium: The case of the crisis in Southeast Asian area during 1997-1999. 2001. International Journal of Social Economics, 28, 19-67
Agley, S. 2005. Human capital inflation and unemployment.International Journal of Social Economics, 22, 5, 4-14.
Angel, N. R. 2008. Prolegomena to any future study in economics and finance as a science: The road to a third revolution in economic and financial thinking. International Journal of Social Economics, 25, 5, 539-606.
Capeta, Tamara. 2004. "Legal Framework of the European Monetary System and the European Monetary Union".
Carlos, G., Luis, A. R., & Santiago, D. D. S. June 06, 2008. Accounting for Irish growth: a balance-of-payments-constraint approach. Journal of Post Keynesian Economics, 30, 3, 409-433.
Cencini, A. 2009.Monetary theory: National and international. London: Routledge
Égert, B. A. L. A. Z. S., &Kierzenkowski, R. A. F. A., January 01, 2009. Asymmetric Fluctuation Bands in the ERM and ERM II : Lessons and Challenges for New EU Member States of Central and Eastern Europe. Eastern European Economics, 43, 1, 82-115.
Garcimartín, C., Rivas, L. A., &Martínez, P. G. January 01, 2010. On the role of relative prices and capital flows in balance-of-payments-constrained growth: the experiences of Portugal and Spain in the euro area. Journal of Post Keynesian Economics, 33, 2, 281-306
Jani, B. E. K. O., &Mejra, F. E. S. T. I. C. July 01, 2004. Disinflation in Slovenia : Evidence from an Iterative Multisectoral Model. Eastern European Economics, 42, 4, 81-103.
Joaquin, R. S.2009. Trade between asymmetrical democratic countries. Journal of Economic Studies, 26, 412-426.
Jocelyn, H. 2004. Eight conjectures about exchange rates. Journal of Economic Studies, 31, 6, 524-548.
John E. Floyd. 2010. Interest Rates, Exchange Rates and World Monetary Policy. Springer Berlin Heidelberg
Kopits, George. 2000. How Can Fiscal Policy Help Avert Currency Crises?. International Monetary Fund
Lal, D. 2007.The Political Economy of Economic Liberalization.The World Bank Economic Review, 1, 2, 273-299
McKay, J., Volz, U., &Wölfinger, R. August 31, 2011. Regional Financing Arrangements and the Stability of the International Monetary System. Journal of Globalization and Development, 2, 1
Solsten, Eric,. 2009. Portugal: A country study. Washington, D.C: For sale by the Supt. of Docs., U.S. G.P.O.