The European Union (EU) is a brotherhood of 27 member states that started from a tiny gang of six neighboring states in 1951.
By the magical powers of the Treaty of Maastricht, it then grew into a large economic and political bloc, making it the largest economic region in the world.
Talk about playing a huge role in international trade and global economic affairs!
Among these EU member states, 19 countries adopted the euro (EUR) as their common currency.
These nations comprise the eurozone, which is also called the European Monetary Union (EMU) or Euroland.
Members of this elite club are Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain.
Aside from adopting a common currency, these nations also share the same monetary policy set by the European Central Bank (ECB).
The eurozone, which comprises more than half of the nations in the EU, ranks as the largest economy with a GDP of $18.45 trillion in 2011. Being a services-oriented economy, services account for a whopping 70% of its GDP!
On top of that, the eurozone takes pride in being the second most attractive investment market for domestic and international investors.
As an economic union, the eurozone has a standardized system of laws, particularly for trade. The size of their entire economy makes the eurozone a major player in the international trade arena.
Because the individual countries are grouped as one entity, it enables them to facilitate trade more easily, mostly with its number one trade partner, the U.S.
This active participation in international trade also significantly impacts the role of the EUR as a reserve currency.
This is because countries that transact with the eurozone need to have a significant amount of reserve currencies in order to reduce exchange rate risk and minimize transaction costs.
Monetary & Fiscal Policy
The European Central Bank (ECB) acts as the governing body for the monetary policy of the EU. Led by the current ECB President Christine Lagarde, the Executive Board also consists of the ECB Vice President and four other policymakers.
Along with the top guns from the national central banks within the euro zone, they make up the ECB Governing Council which votes on monetary policy changes.
The main objective of the ECB is to maintain price stability in the entire region – quite a tall order! To achieve this goal, the eurozone signed the Maastricht Treaty which applied a certain set of criteria for the member nations. Here are some of the requirements:
The nation’s inflation rate must not exceed the average inflation of the three best-performing (lowest inflation rates) states by more than 1.5%.
Their long-term interest rates must not exceed the average rates of these low-inflation states by more than 2%.
Exchange rates must stay within the range of the exchange rate mechanism for at least a couple of years.
Their government deficit must be less than 3% of their GDP.
If a nation fails to meet these conditions, they are penalized with a hefty fine.
The ECB also makes use of its minimum bid rate and open market operations as its monetary policy tools. The ECB minimum bid rate or repo rate is the rate of return the central bank offers to the central banks of its member states. They make use of this rate to control inflation.
Open market operations, on the other hand, are used to manage interest rates, control liquidity, and establish monetary policy stance. Such operations are conducted through the buying or selling of government securities in the market.
In order to increase liquidity, the ECB buys securities and pays with euros, which then gets circulated. Conversely, to mop up excess liquidity, the ECB sells securities in exchange for euros.
Conversely, to mop up excess liquidity, the ECB sells securities in exchange for euros.
Other than making use of those monetary policy tools, the ECB can also opt to intervene in the foreign exchange market to further cap inflation. Because of this, traders pay close attention to comments from the Governing Council members since these could impact the EUR.