Jerry Mushin, Victoria University of Wellington
The establishment, in 1999, of the euro was not an isolated event. It was the latest installment in the continuing story of attempts to move towards economic and monetary integration in western Europe. Its relationship with developments since 1972, when the Bretton Woods system of fixed (but adjustable) exchange rates in terms of the United States dollar was collapsing, is of particular interest.
Political moves towards monetary cooperation in western Europe began at the end of the Second World War, but events before 1972 are beyond the scope of this article. Coffey and Presley (1971) have described and analyzed relevant events between 1945 and 1971.
In May 1972, at the end of the Bretton Woods (adjustable-peg) system, many countries in western Europe attempted to stabilize their currencies in relation to each other’s currencies. The arrangements known as the Snake in the Tunnel (or, more frequently, as the Snake), which were set up by members of the European Economic Community (EEC), one of the forerunners of the European Union, lasted until 1979. Each member agreed to limit, by market intervention, the fluctuations of its currency’s exchange rate in terms of other members’ currencies. The maximum divergence between the strongest and the weakest currencies was 2.25%. The agreement meant that the French government, for example, would ensure that the value of the French franc would show very limited fluctuation in terms of the Italian lira or the Netherlands guilder, but that there would be no commitment to stabilize its fluctuations against the United States dollar, the Japanese yen, or other currencies outside the agreement.
This was a narrower objective than the aim of the adjustable-peg system, which was intended to stabilize the value of each currency in terms of the values of all other major currencies, but for which the amount of reserves held by governments had proved to be insufficient. It was felt that this limited objective could be achieved with the amount of reserves available to member governments.
The agreement also had a political dimension. Stable exchange rates are likely to encourage international trade, and it was hoped that the new exchange-rate regime would stimulate members’ trade within western Europe at the expense of their trade with the rest of the world. This was one of the objectives of the EEC from its inception.
Exchange rates within the group of currencies were to be managed by market intervention; member governments undertook to buy and sell their currencies in sufficiently large quantities to influence their exchange rates. There was an agreed maximum divergence between the strongest and weakest currencies. Exchange rates of the whole group of currencies fluctuated together against external denominators such as the United States dollar.
The Snake is generally regarded as a failure. Membership was very unstable; the United Kingdom and the Irish Republic withdrew after less than one month, and only the German Federal Republic remained a member for the whole of its existence. Other members withdrew and rejoined, and some did this several times. In addition, the political context of the Snake was not clearly defined. Sweden and Norway participated in the Snake although, at that time, neither of these countries was a member of the EEC and Sweden was not a candidate for admission.
The curious name of the Snake in the Tunnel comes from the appearance of exchange-rate graphs. In terms of a non-member currency, the value of each currency in the system could fluctuate but only within a narrow band that was also fluctuating. The trend of each exchange rate showed some resemblance to a snake inside the narrow confines of a tunnel.
European Monetary System
The Snake came to an end in 1979 and was replaced with the European Monetary System (EMS). The exchange-rate mechanism of the EMS had the same objectives as the Snake, but the procedure for allocating intervention responsibilities among member governments was more precisely specified.
The details of the EMS arrangements have been explained by Adams (1990). Membership of the EMS involved an obligation on each EMS-member government to undertake to stabilize its currency value with respect to the value of a basket of EMS-member currencies called the European Currency Unit (ECU). Each country’s currency had a weight in the ECU that was related to the importance of that country’s trade within the EEC. An autonomous shift in the external value of any EMS-member currency changed the value of the ECU and therefore imposed exchange-rate adjustment obligations on all members of the system. The magnitude of each of these obligations was related to the weight allocated to the currency experiencing the initial disturbance.
The effects of the EMS requirements on each individual member depended upon that country’s weight in the ECU. The system ensured that major members delegated to their smaller partners a greater proportion of their exchange-rate adjustment responsibilities than the less important members imposed on the dominant countries. The explanation for this lack of symmetry depends on the fact that a particular percentage shift in the external value of the currency of a major member of the EMS (with a high weight in the ECU) had a greater effect on the external value of the ECU than had the same percentage disturbance to the external value of the currency of a less important member. It therefore imposed greater exchange-rate adjustment responsibilities on the remaining members than did the same percentage shift applied to the external value of the less important currency. While each of the major members of the EMS could delegate to the remaining members a high proportion of its adjustment obligations, the same is not true for the smaller countries in the system. This burden was, however, seen by the smaller nations (including Denmark, Belgium, and Netherlands) as an acceptable price for exchange-rate stability with their main trading partners (including France and the German Federal Republic).
The position of the Irish Republic, which joined the EMS in 1979 despite both the very low weight of its currency in the ECU and the absence of the UK, its dominant trading partner, appears to be anomalous. The explanation of this decision is that it was principally concerned about the significant problem of imported inflation that was derived from the rising price level of its British imports. This was based on the assumption that, once the rigid link between the two currencies was broken, inflation in the UK would lead to a fall in the value of the British pound relative to the value of the Irish Republic pound. However, purchasing power is not the only determinant of exchange rates, and the value of the British pound increased sharply in 1979 causing increased imported inflation in the Irish Republic. The appreciation of the British pound was probably caused principally by developments in the UK oil industry and by the monetarist style of UK macroeconomic policy.
Partly because it had different rules for different countries, the EMS had a more stable membership than had the Snake. The standard maximum exchange-rate fluctuation from its reference value that was permitted for each EMS currency was ±2.25%. However, there were wider bands (±6%) for weaker members (Italy from 1979, Spain from 1989, and the UK from 1990) and the Netherlands observed a band of ±1%. The system was also subject to frequent realignments of the parity grid. The Irish Republic joined the EMS in 1979 but the UK did not, thus ending the link between the British pound and the Irish Republic pound. The UK joined in 1990 but, as a result of substantial international capital flows, left in 1992. The bands were increased in width to ±15% in 1992.
Incentives to join the EMS were comparable to those that applied to the Snake and included the desire for stable exchange rates with a country’s principal trading partners and the desire to encourage trade within the group of EMS members rather than with countries in the rest of the world. Cohen (2003), in his analysis of monetary unions, has explained the advantages and disadvantages of trans-national monetary integration.
The UK decided not to participate in the exchange-rate mechanism of the EMS at its inception. It was influenced by the fact that the weight allocated to the British pound (0.13) in the definition of the ECU was insufficient to allow the UK government to delegate to other EMS members a large proportion of the exchange-rate stabilization responsibilities that it would acquire under EMS rules. The outcome of EMS membership for the UK in 1979 would have been, therefore, in marked contrast to the outcome for France (with an ECU-weight of 0.20) and, especially, for the German Federal Republic (with an ECU-weight of 0.33). The proportion of the UK’s exports that, at that time, was sold in EMS countries was low relative to the proportion of any other EMS-member’s exports, and this was reflected in its ECU weight. The relationship between the weight assigned to an individual EMS-member’s currency in the definition of the ECU and the ability of that country to delegate adjustment responsibilities was that a particular percentage shift in the external value of the currency of a major member of the EMS had a greater effect on the value of the ECU than the same percentage disturbance to the external value of the currency of a less important member, and it therefore imposed greater exchange-rate adjustment responsibilities on the remaining EMS members than did the same percentage shift applied to the external value of the less important EMS-member currency.
A second reason for the refusal of the UK to join the EMS in 1979 was that membership would not have led to greater stability of its exchange rates with respect to the currencies of its major trading partners, which were, at that time, outside the EMS group of countries.
An important reason for the British government’s continued refusal, for more than eleven years, to participate in the EMS was its concern about the loss of sovereignty that membership would imply. A floating exchange rate (even a managed floating exchange rate such as was operated by the UK government from 1972 to 1990) permits an independent monetary policy, but EMS obligations make this impossible. Monetarist views on the efficacy of restraining the rate of inflation by controlling the rate of growth of the money supply were dominant during the early years of the EMS, and an independent monetary policy was seen as being particularly significant.
By 1990, when the UK government decided to join the EMS, a number of economic conditions had changed. It is significant that the proportion of UK exports sold in EMS countries had risen markedly. Following substantial speculative selling of British currency in September 1992, however, the UK withdrew from the EMS. One of the causes of this was the substantial flow of short-term capital from the UK, where interest rates were relatively low, to Germany, which was implementing a very tight monetary policy and hence had very high interest rates. This illustrates that a common monetary policy is one of the necessary conditions for the operation of agreements, such as the EMS, that are intended to limit exchange-rate fluctuations.
Despite the partial collapse of the EMS in 1992, a common currency, the euro, was introduced in 1999 by eleven of the fifteen members of the European Union, and a twelfth country joined the euro zone in 2001. From 1999, each national currency in this group had a rigidly fixed exchange rate with the euro (and, hence, with each other). Fixed exchange rates, in national currency units per euro, are listed in Table 1. In 2002, euro notes and coins replaced national currencies in these countries. The intention of the new currency arrangement is to reduce transactions costs and encourage economic integration. The Snake and the EMS can perhaps be regarded as transitional structures leading to the introduction of the euro, which is the single currency of a single integrated economy.
Value of the Euro (in terms of national currencies)
Source: European Central Bank
Of the members of the European Union, to which participation in this innovation was restricted, Denmark, Sweden, and the UK chose not to introduce the euro in place of their existing currencies. The countries that adopted the euro in 1999 were Austria, Belgium, France, Finland, Germany, Irish Republic, Italy, Luxembourg, Netherlands, Portugal, and Spain.
Greece, which adopted the euro in 2001, was initially excluded from the new currency arrangement because it had failed to satisfy the conditions described in the Treaty of Maastricht, 1991. The maximum value for each of five variables for each country that was specified in the Treaty is listed in Table 2.
Conditions for Euro Introduction (Treaty of Maastricht, 1991)
|Inflation rate||1.5 percentage points above the average of the three euro countries with the lowest rates|
|Long-term interest rates||2.0 percentage points above the average of the three euro countries with the lowest rates|
|Exchange-rate stability||fluctuations within the EMS band for at least two years|
|Budget deficit/GDP ratio||3%|
|Government debt/GDP ratio||60%|
Source: The Economist, May 31, 1997.
The euro is also used in countries that, before 1999, used currencies that it has replaced: Andorra (French franc and Spanish peseta), Kosovo (German mark), Monaco (French franc), Montenegro (German mark), San Marino (Italian lira), and Vatican (Italian lira). The euro is also the currency of French Guiana, Guadeloupe, Martinique, Mayotte, Réunion, and St Pierre-Miquelon that, as départements d’outre-mer, are constitutionally part of France.
The euro was adopted by Slovenia in 2007, by Cyprus (South) and Malta in 2008, by Slovakia in 2009, by Estonia in 2011, by Latvia in 2014, and by Lithuania in 2015. Table 3 shows the exchange rates between the euro and the currencies of these countries.
Table 3 Value of the Euro (in terms of national currencies)
Source: European Central Bank
Currencies whose exchange rates were, in 1998, pegged to currencies that have been replaced by the euro have had exchange rates defined in terms of the euro since its inception. The Communauté Financière Africaine (CFA) franc, which is used by Benin, Burkina Faso, Cameroon, Central African Republic, Chad, Congo Republic, Côte d’Ivoire, Equatorial Guinea, Gabon, Guinea-Bissau, Mali, Niger, Sénégal, and Togo was defined in terms of the French franc until 1998, and is now pegged to the euro. The Comptoirs Français du Pacifique (CFP) franc, which is used in the three French territories in the south Pacific (Wallis and Futuna Islands, French Polynesia, and New Caledonia), was also defined in terms of the French franc and is now pegged to the euro. The Comoros franc has similarly moved from a French-franc peg to a euro peg. The Cape Verde escudo, which was pegged to the Portuguese escudo, is also now pegged to the euro. Bosnia-Herzegovina and Bulgaria, which previously operated currency-board arrangements with respect to the German mark, now fix the exchange rates of their currencies in terms of the euro. Botswana, Croatia, Czech Republic, Denmark, Hungary, Iran, Macedonia, Poland, Romania, São Tomé-Príncipe, and Serbia also peg their currencies to the euro. Additional countries that peg their currencies to a basket that includes the euro are Algeria, Azerbaijan, Belarus, China, Fiji, Kuwait, Libya, Morocco, Samoa (Western), Singapore, Syria, and Vanuatu. Switzerland, which does not operate a fixed exchange-rate system, occasionally intervenes to smooth extreme fluctuations, in terms of the euro, of its exchange rate (European Central Bank, 2018).
The group of countries that use the euro or that have linked the values of their currencies to the euro might be called the “greater euro zone.” It is interesting that membership of this group of countries has been determined largely by historical accident. Its members exhibit a marked absence of macroeconomic commonality. Within this bloc, macroeconomic indicators, including the values of GDP and of GDP per person, have a wide range of values. The degree of financial integration with international markets also varies substantially in these countries. Countries that stabilize their exchange rates with respect to a basket of currencies that includes the euro have adjustment systems that are less closely related to its value. This weaker connection means that these countries should not be regarded as part of the greater euro zone.
The establishment of the euro is a remarkable development whose economic effects, especially in the long term, are uncertain. This type of exercise, involving the rigid fixing of certain exchange rates and then the replacement of a group of existing currencies, has rarely been undertaken in the recent past. Other than the introduction of the euro, and the much less significant case of the merger in 1990 of the former People’s Democratic Republic of Yemen (Aden) and the former Arab Republic of Yemen (Sana’a), the monetary union that accompanied the expansion of the German Federal Republic to incorporate the former German Democratic Republic in 1990 is the sole recent example. However, the very distinctive political situation of post-1945 Germany (and its economic consequences) make it difficult to draw relevant conclusions from this experience. The creation of the euro is especially noteworthy at a time when the majority, and an increasing proportion, of countries have chosen floating (or managed floating) exchange rates for their currencies. With the important exception of China, this includes most major economies. This statement should be treated with caution, however, because countries that claim to operate a managed floating exchange rate frequently aim, as described by Calvo and Reinhart (2002), to stabilize their currencies with respect to the United States dollar.
When the euro was established, it replaced national currencies. However, this is not the same as the process known as dollarization, in which a country adopts another country’s currency. For example, the United States dollar is the sole legal tender in Ecuador, El Salvador, Marshall Islands, Micronesia, Palau, Panama, Timor-Leste, and Zimbabwe. It is also the sole legal tender in the overseas possessions of the United States (American Samoa, Guam, Northern Mariana Islands, Puerto Rico, and U.S. Virgin Islands), in two British territories (Turks and Caicos Islands and British Virgin Islands) and in the Caribbean Netherlands. Like the countries that use the euro, a dollarized country cannot operate an independent monetary policy. A euro-using country will, however, have some input into the formation of monetary policy, whereas dollarized countries have none. In addition, unlike euro-using countries, dollarized countries probably receive none of the seigniorage that is derived from the issue of currency.
Prospects for the Euro
The expansion of the greater euro zone, which is likely to continue with the economic integration of the new members of the European Union, and with the probable admission of additional new members, has enhanced the importance of the euro. However, this expansion is unlikely to make the greater euro zone into a major currency bloc comparable to, for example, the Sterling Area even at the time of its collapse in 1972. Mushin (2012) has described the nature and role of the Sterling Area
Mundell (2003) has predicted that the establishment of the euro will be the model for a new currency bloc in Asia. However, there is no evidence yet of any significant movement in this direction. Eichengreen et al (1995) have argued that monetary unification in the emerging industrial economies of Asia is unlikely to occur. A feature of Mundell’s paper is that he assumes that the benefits of joining a currency area almost necessarily exceed the costs, but this remains unproven.
The creation of the euro will have, and might already have had, macroeconomic consequences for the countries that comprise the greater euro zone. Since 1999, the influences on the import prices and export prices of these countries have included the effects of monetary policy run by the European Central Bank (www.ecb.int), a non-elected supra-national institution that is directly accountable neither to individual national governments nor to individual national parliaments, and developments, including capital flows, in world financial markets. Neither of these can be relied upon to ensure stable prices at an acceptable level in price-taking economies. The consequences of the introduction of the euro might be severe in some parts of the greater euro zone, especially in the low-GDP economies. For example, unemployment might increase if exports cease to have competitive prices. Further, domestic macroeconomic policy is not independent of exchange-rate policy. One of the costs of joining a monetary union is the loss of monetary-policy independence.
Data on Exchange-rate Policies
The best source of data on exchange-rate policies is probably the International Monetary Fund (IMF) (see www.imf.org). Almost all countries of significant size are members of the IMF; notable exceptions are Cuba (since 1964), the Republic of China (Taiwan) (since 1981), and the People’s Democratic Republic of Korea (North Korea). The most significant IMF publications that contain exchange-rate data are International Financial Statistics and the Annual Report on Exchange Arrangements and Exchange Restrictions.
Since 2009, the IMF has allocated each country’s exchange rate policy to one of ten categories. Unfortunately, the definitions of these mean that the members of the greater euro zone are not easy to identify. In this taxonomy, the exchange rate systems of countries that are part of a monetary union are classified according to the arrangements that govern the joint currency. The exchange rate policies of the eleven countries that introduced the euro in 1999, Cyprus (South), Estonia, Greece, Latvia, Lithuania, Malta, Slovakia, and Slovenia are classified as “Free floating.” Kosovo, Montenegro, and San Marino have “No separate legal tender.” Bosnia-Herzegovina and Bulgaria have “Currency boards.” Cape Verde, Comoros, Denmark, Fiji, Kuwait, Libya, Morocco, São Tomé and Príncipe, and the fourteen African countries that use the CFA franc have “Conventional pegs.” Botswana has a “crawling peg.” Croatia, Macedonia, and Singapore have a “Stabilized arrangement.” Croatia has a “Crawl-like arrangement.” Andorra, Monaco, Vatican, and the three territories in the south Pacific that use the CFP franc are not IMF members. Anderson, Habermeier, Kokenyne, and Veyrune (2009) explain and discuss the definitions of these categories and compare them to the definitions that were used by the International Monetary Fund until 2010. Information on the exchange-rate policy of each of its members is published by the International Monetary Fund (2018).
Other Monetary Unions in Europe
The establishment of the Snake, the EMS, and the euro have affected some of the other monetary unions in Europe. The monetary unions of Belgium-Luxembourg, of France-Monaco, and of Italy-Vatican-San Marino predate the Snake, survived within the EMS, and have now been absorbed into the euro zone. Unchanged by the introduction of the euro are the UK-Gibraltar-Guernsey-Isle of Man-Jersey monetary union (which is the remnant of the Sterling Area that also includes Falkland Islands and St. Helena), the Switzerland-Liechtenstein monetary union, and the use of the Turkish lira in Northern Cyprus.
The relationship between the currencies of the Irish Republic (previously the Irish Free State) and the UK is an interesting case study of the interaction of political and economic forces on the development of macroeconomic (including exchange-rate) policy. Despite the non-participation of the UK, the Irish Republic was a foundation member of the EMS. This ended the link between the British pound and the Irish Republic pound (also called the punt) that had existed since the establishment of the Irish currency following the partition of Ireland (1922), so that a step towards one monetary union destroyed another. Until 1979, the Irish Republic pound had a rigidly fixed exchange rate with the British pound, and each of the two banking systems cleared the other’s checks as if denominated in its own currency. These very close financial links meant that every policy decision of monetary importance in the UK coincided with an identical change in the Irish Republic, including the currency reforms of 1939 (US-dollar peg), 1949 (devaluation), 1967 (devaluation), 1971 (decimalization), 1972 (floating exchange rate), and 1972 (brief membership of the Snake). From 1979 until 1999, when the Irish Republic adopted the euro, there was a floating exchange rate between the British pound and the Irish Republic pound. South of the Irish border, the dominant political mood in the 1920s was the need to develop a distinct non-British national identity, but there were perceived to be good economic grounds for retaining a very close link with the British pound. By 1979, although political rhetoric still referred to the desire for a united Ireland, the economic situation had changed, and the decision to join the EMS without the membership of the UK meant that, for the first time, different currencies were used on each side of the Irish border. In both of these cases, political objectives were tempered by economic pressures.
Effects of the Global Financial Crisis
One of the ways of analyzing the significance of a new system is to observe the effects of circumstances that have not been predicted. The global financial crisis [GFC] that began in 2007 provides such an opportunity. In the UK and in the Irish Republic, whose business cycles are usually comparable, the problems that followed the GFC were similar in nature and in severity. In both of these countries, major banks (and therefore their depositors) were rescued from collapse by their governments. However, the macroeconomic outcomes have been different. The increase in the unemployment rate has been much greater in the Irish Republic than in the UK. The explanation for this is that an independent monetary policy is not possible in the Irish Republic, which is part of the euro zone. The UK, which does not use the euro, responded to the GFC by operating a very loose monetary policy (with a very low discount rate and large scale “quantitative easing”). The effects of this have been compounded by depreciation of the British pound. Although, partly because of the common language, labor is mobile between the UK and the Irish Republic, the unemployment rate in the Irish Republic remains high because its real exchange rate is high and its real interest rates are high. The effect of the GFC is that the Irish Republic now has an overvalued currency, which has made an inefficient economy more inefficient. Simultaneously, the more efficient economies in the euro zone (and some countries that are outside the euro zone, including the UK, whose currencies have depreciated) now have undervalued currencies, which have encouraged their economies to expand. This illustrates one of the consequences of membership of the euro zone. Had the GFC been predicted, the estimation of the economic benefits for the Irish Republic (and for Greece, Italy, Portugal, Spain, and other countries) would probably have been different. The political consequences for the more efficient countries in the euro zone, including Germany, might also be significant. At great cost, these countries have provided financial assistance to the weaker members of the euro zone, especially Greece.
The future role of the euro is uncertain. Especially in view of the British decision to withdraw from the European Union, even its survival is not guaranteed. It is clear, however, that the outcome will depend on both political and economic forces.
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Jerry Mushin can be reached at email@example.com. This article includes material from some of the author’s publications:
Mushin, Jerry. “A Simulation of the European Monetary System.” Computer Education 35 (1980): 8-19.
Mushin, Jerry. “The Irish Pound: Recent Developments.” Atlantic Economic Journal 8, no, 4 (1980): 100-10.
Mushin, Jerry. “Exchange-Rate Adjustment in a Multi-Currency Monetary System.” Simulation 36, no 5 (1981): 157-63.
Mushin, Jerry. “Non-Symmetry in the European Monetary System.” British Review of Economic Issues 8, no 2 (1986): 85-89.
Mushin, Jerry. “Exchange-Rate Stability and the Euro.” New Zealand Banker 11, no. 4 (1999): 27-32.
Mushin, Jerry. “A Taxonomy of Fixed Exchange Rates.” Australian Stock Exchange Perspective 7, no. 2 (2001): 28-32.
Mushin, Jerry. “Exchange-Rate Policy and the Efficacy of Aggregate Demand Management.” The Business Economist 33, no. 2 (2002): 16-24.
Mushin, Jerry. Output and the Role of Money. New York, London and Singapore: World Scientific Publishing Company, 2002.
Mushin, Jerry. “The Deceptive Resilience of Fixed Exchange Rates.” Journal of Economics, Business and Law 6, no. 1 (2004): 1-27.
Mushin, Jerry. “The Uncertain Prospect of Asian Monetary Integration.” International Economics and Finance Journal 1, no. 1 (2006): 89-94.
Mushin, Jerry. “Increasing Stability in the Mix of Exchange Rate Policies.” Studies in Business and Economics 14, no. 1 (2008): 17-30.
Mushin, Jerry. “Predicting Monetary Unions.” International Journal of Economic Research 5, no. 1 (2008): 27-33.
Mushin, Jerry. Interest Rates, Prices, and the Economy. Jodhpur: Scientific Publishers (India), 2009.
Mushin, Jerry. “Infrequently Asked Questions on the Monetary Union of the Countries of the Gulf Cooperation Council.” Economics and Business Journal: Inquiries and Perspectives, 3, no. 1, (2010): 1-12.
Mushin, Jerry. “Common Currencies: Economic and Political Causes and Consequences.” The Business Economist 42, no. 2, (2011): 19-26.
Mushin, Jerry. “Exchange Rates, Monetary Aggregates, and Inflation,” Bulletin of Political Economy 7, no. 1 (2013): 69-88.
Citation: Mushin, Jerry. “The Euro and Its Antecedents”. EH.Net Encyclopedia, edited by Robert Whaples. October 9, 2018. URL http://eh.net/encyclopedia/the-euro-and-its-antecedents/