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Will Latvia join the Euro?

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Ints Kalnins/Reuters/File

(Read caption) Latvia's lats and euro banknotes are seen in this illustration picture in Riga, Latvia. Since Latvia has for a long time pegged its currency, the Lat, to the Euro, joining the Euro wouldn't mean any loss in monetary policy independence, Karlsson writes.

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While there is talk in some euro area countries, most notably Italy, about exiting the euro, Latvia remains determined to join in 2014. Since Latvia has for a long time pegged its currency, the lat, to the euro this wouldn't mean any loss in monetary policy independence, only that the transaction costs associated with a separate unit would disappear.

However, unlike those who have already joined, Latvia is forced to meet certain criteria. It has no problem meeting the criteria of exchange rate stability, or the fiscal criterias, but it does face the potential problem of having too high inflation. Since it can't have inflation more than 1.5 percentage points above the average of the lowest three EU-countries (including those with independent floating currencies) and since Latvia has the fastest growth in the EU (more than 5% at a time when most other countries have negative growth), and since given a fixed exchange rate higher growth tends to be associated with higher inflation (because of for example the Balassa-Samuelsson effect), this raises a potential obstacle to euro entry.

However, it would seem that there is in fact no problem. Latvia's inflation was only 0.3% in February, the second lowest (after Greece). But how could inflation have fallen so much even as growth was high? Simple, they decided to do the opposite of what the Southern European countries have done and lowered taxes, especially the VAT. A lower VAT will provide a positive supply shock and lower prices while also boosting real income.

That the purpose of this VAT cut was to lower price inflation just in time for when it will be decided if Latvia meets the criteria is evident by the fact that it was implemented in July 2012, just in time for the annual average inflation rate to be lowered when the meeting about Latvia's entry will be held during the early summer. And indeed, Latvian officials are admitting that a key purpose of the VAT cut was to qualify Latvia for the euro.


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