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INTRODUCTION
The European Union (EU) is an economic and political union of 27 member states which are located primarily in Europe. The EU traces its origins from the European Coal and Steel Community (ECSC) and the European Economic Community (EEC), formed by six countries in 1951 and 1958 respectively. The Maastricht Treaty established the European Union under its current name in 1993. The latest amendment to the constitutional basis of the EU, the Treaty of Lisbon, came into force in 2009. The EU operates through a system of supranational independent institutions and intergovernmental negotiated decisions by the member states. Important institutions of the EU include the European Commission, the Council of the European Union, the European Council, the Court of Justice of the European Union, and the European Central Bank. The EU is unlike anything elseit isn't a government, an association of states, or an international organization. Rather, the 27 Member States have relinquished part of their sovereignty to EU institutions, with many decisions made at the European level

They are divided into 27 EU member countries, 6 countries which have applied for EU membership (candidate countries and potential candidate countries) and other countries.

Acceding Country Croatia (expected to become the 28th member state of the EU on 1 July 2013 after a referendum on EU membership was approved by Croatian voters on 22 January 2012. The Croatian accession treaty still has to be ratified by all current EU member states) Candidate Countries Former Yugoslav Republic of Macedonia Iceland Montenegro Serbia Turkey Potential candidates Albania Bosnia and Herzegovina Kosovo under UN Security Council Resolution 1244
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FLAG OF EU

The flag of Europe consists of a circle of 12 golden (yellow) stars on an azure background. It is the flag and emblem of the Council of Europe (CoE) and the European Union (EU). It is also often used to indicate euro zone countries, and, more loosely, to represent the continent of Europe or the countries of Europe independent of any of these institutions. The number of stars does not vary according to the members of either organisation as they are intended to represent all the peoples of Europe, even those outside the EU, but inside the CoE.

CURRENCIES OF EU

There are eleven currencies of the European Union as of 2011, the principal currency being the Euro. The Euro is used by the institutions of the European Union and by the Eurozone states, which account for 17 of the 27 member states of the European Union. Although all but two states are obliged to adopt the currency there are three states which have, through legal exemption or de facto permission, retained the right to operate independent currencies within the European Union. The remaining seven states must join the ERM II and attain the third stage and adopt the Euro eventually.

GOVERNANCE
The European Union has seven institutions: the European Parliament, the Council of the European Union, the European Commission, the European Council, the European Central Bank, the Court of Justice of the European Union and the European Court of Auditors. Competencies in scrutinising and amending legislation are divided between the European Parliament and the Council of the European Union while executive tasks are carried out by the European Commission and in a limited capacity by the European Council. The monetary policy of the eurozone is governed by the European Central Bank. The interpretation and the application of EU law and the treaties are ensured by the Court of Justice of the European Union. The EU budget is scrutinised by the European Court of Auditors. There are also a number of ancillary bodies which advise the EU or operate in a specific area.
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MAJOR TRADE PARTNERS

The major trade partners of EU are US, China, Russia, Switzerland, Norway, Turkey, Japan, India, Brazil, etc.

MONETARY POLICY
The European Central Bank (ECB) assumed responsibility for monetary policy decision-making in the euro area . The transfer of this responsibility from national central banks (NCBs) to a new supranational institution represented a milestone in a long and complex process of integration among European countries. The legal basis for the single monetary policy is laid down in the Treaty on European Union (TEU), the Treaty on the Functioning of the European Union (TFEU), and the Statute of the European System of Central Banks and of the European Central Bank (the Statute of the ESCB). The Eurosystem is made up of the ECB and the NCBs of the EU Member States whose currency is the euro, whereas the ESCB comprises the ECB and the NCBs of all EU Member States. Activities of the ECB

Ensuring that EU prices are stable Managing EU interest rates and money supply Providing liquidity to the system when needed
If an EU country joins the Euro zone its central bank cedes much of its power to the ECB
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Objective of the Monetary Policy

The Treaty makes clear that ensuring price stability is the most important contribution that the Monetary Policy can make.

Benefits of Price Stability

Improving the transparency of the price mechanism Reducing inflation risk premium in interest rates Avoiding unproductive activities to hedge against the negative impact of inflation or deflation Contributing to financial stability.

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SCOPE OF THE MONETARY POLICY

The Eurosystem is the sole issuer of banknotes and bank reserves in the euro area. This makes it the monopoly supplier of the monetary base, which consists of currency (banknotes and coins) in circulation, the reserves held by counterparties with the Eurosystem, and recourse by credit institutions to the Eurosystems deposit facility

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Change in official interest rates Affects banks and money-market interest rates Affects expectations Affects asset prices Affects saving and investment decisions Affects the supply of credit Leads to changes in aggregate demand and prices Affects the supply of bank loans
CRITICISMS
Inflexibility of Monetary Policy Since membership of the eurozone establishes a single monetary policy, individual member states can no longer act independently, preventing them from printing money in order to pay creditors and ease their risk of default. By "printing money" a country's currency is devalued relative to its (eurozone) trading partners, making its exports cheaper, in principle leading to an improved balance of trade, increased GDP and higher tax revenues in nominal terms. 12

CURRENCY REGIME OF ECB

In a world with full capital mobility it is not possible for a country to have at one and the same time a fixed (or tightly managed) exchange rate regime and an independent monetary policy. If a country pegs or manages its exchange rate, it will have to run a monetary policy consistent with such a choice.

In particular, its monetary policy will be determined not by its own requirements but by the requirements of the foreign country to whose currency it is pegged.
Under the Bretton Woods regime, the monetary policies of countries in Europe were determined by a need to maintain the dollar peg. breakdown of the system in the early 1970s 1992-93 crisis showed For monetary policy to be targeted effectively at domestic objectives, rather than at those of another country, it has to be freed from any exchange rate commitment, i.e. the country must have a flexible exchange rate system

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Implications of adopting a flexible exchange rate system

One key aspect is that the external value of the currency is determined by the financial markets. This means that the exchange rate is not - and cannot be - an instrument of economic policy.

This concept is well understood by economists and market participants, but not always in the political sphere.
In fact, markets are often concerned that the exchange rate is used as instrument of economic or trade policy, or as a way to influence monetary policy. These concerns tend to discourage foreign investment. This is the reason why the US devised its strong dollar policy, which is not a policy aimed at achieving a certain exchange rate for the dollar. Indeed, the policy has been maintained when the dollar appreciated and when it depreciated. Rather, its a commitment not to manipulate the exchange rate to achieve a competitive advantage
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Reasons For flexible exchange rate regime

First, market prices of financial assets, including the exchange rate, may at times deviate significantly from underlying fundamentals and develop into dynamics of their own. This point is widely accepted in the economics literature and even among financial market practitioners.

Second, the exchange rate is an important variable, which affects other relevant ones in the economy, such as inflation, competitiveness, exports and imports. Therefore, even if a country adopts a flexible exchange rate regime, this does not mean that it has no exchange rate policy. What are the main ingredients of an exchange rate policy?
There are four sequential steps: Step 1: Monitoring and assessing exchange rate markets and developments, in particular with respect to the underlying fundamentals; Step 2: Discussing market developments with the other major partners and assess the configuration of different exchange rate developments and policies; Step 3: Making public statements on the situation of the foreign exchange markets and on exchange rate policies; Step 4: Intervening in the foreign exchange markets. 15

Does the euro area have all the instruments it needs to implement its policy effectively?
Step 1. Exchange rate developments are regularly monitored and discussed at the technical level between the ECB and the Eurogroup. The Chair of the Euro Working Group the group of high-level representatives of the euro area Finance Ministers which form the Eurogroup and the member of the Executive Board of the ECB in charge of international relations have regular exchanges of views on market developments and provide input to the policy discussion between the Eurogroup and the ECB. Since the start of the euro there have been no disagreements at the technical level either on the assessment or on the policy options. Similarly, discussions have never led to differences of views between the ECB and the Eurogroup on the overall situation or on the action to be taken. Common terms of references have often sealed this agreement and have been used in international discussions.

Step 2. Discussions with the other major partners take place at three main levels

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Step 3. Verbal interventions are regularly made on exchange rates in the context of the G7. The Eurogroup and ECB representatives contribute to the preparation of the communiqu. The views expressed by the two representatives have always been consistent and ensured an effective message. It should be mentioned that on a delicate issue such as the exchange rate, frequent declarations by individual policy-makers who have not been delegated to make such statements have no impact at all on the markets; sometimes they may even backfire.

Step 4. Finally, the euro area is fully equipped to conduct foreign exchange interventions. It did so, very effectively, in the Fall of 2000. This instrument is in the hands of the ECB, which can assess when and how to use it in the light of the prevailing market conditions and its monetary policy stance. The ECB will use the instrument when it will consider it appropriate. To sum up, the euro area has all the instruments to implement an effective exchange rate policy of the euro. Contrary to what some observers have suggested, the allocation of responsibility decided in the Treaty is optimal, because it allows for all the relevant authorities to be involved. It provides for the capacity to use the necessary instruments effectively and efficiently.
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Speculation relating to bailout of Spain

1. French daily Le Monde reported that the European Central Bank and euro zone governments are preparing a market intervention to drive down Madrids borrowing costs.

2. German chancellor Angela Merkel and French president Franois Hollande called on EU member states as well as the European institutions to live up to their obligations in their own area of competence
3. Oil fluctuated in London amid speculation that the European Unions economy will fail to grow, as the regions leaders gathered in Brussels for a summit. 4. Economic confidence in the euro area slumped to the lowest in more than 2 1/2 years in June, the European Commission said. Germany reported that unemployment in the regions biggest economy rose for a fourth month this year. 5. Unlimited bond buying 6. European Central Bank President Mario Draghi said policy makers agreed to an unlimited bond- purchase program to regain control of interest rates in the euro area and fight speculation of a currency breakup.
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The Bond Program The ECBs program, called Outright Monetary Transactions, will target government bonds with maturities of one to three years, including longer-dated debt that has a residual maturity of that length, Draghi said. Purchases will be fully sterilized, meaning that the overall impact on themoney supply will be neutral, and the ECB will not have seniority, he said. Effect of Buy Back The pound rose to the highest in more than three months versus the dollar on signs the U.K. recession is easing and as speculation the European Central Bank will announce a plan to buy bonds boosted European currencies. Gilts Sale The 1.75 percent bond maturing in September 2022 fell 0.115 or 1.15 pounds per 1,000- pound face amount, to 101.02. Policy makers will leave the Bank of Englands asset- purchase target at 375 billion pounds, according to the median estimate of economists forecasts in a Bloomberg survey.
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ECONOMIC FUNDAMENTALS
BRUSSELS, Dec. 17 -- EU leaders said at a summit Friday that the fundamentals of their economy remained sound despite the adverse impact of a sovereign debt crisis. "Growth prospects are strengthening and the fundamentals of the European economy are sound," the leaders said after wrapping up a two-day summit here. The EU economy was hit with a sovereign debt crisis this year, with Greece and Ireland already forced to ask for bailouts. The crisis posed the biggest challenge to the euro and cast doubt on economic recovery in the 27-nation bloc, which remained fragile after the financial and economic crisis. In response to the crisis, EU countries, together with the International Monetary Fund, set up a 110-billion-euro (146-billion-dollar) rescue package for Greece and a 750-billion-euro (995billion-dollar) bailout mechanism.

Investors are now worried that Portugal and Spain may soon be the next victims of the sovereign debt crisis as the rescue of Ireland in November did little to hold back the contagion threat of the crisis.
At the year-end summit, EU leaders agreed on a limited change to the Lisbon Treaty in order to set up a permanent bailout mechanism in the euro zone, a key reform to better manage a 20 future crisis.

ECB INTERVENTION
As the sovereign debt crisis in Greece came to a head in the spring of 2010, the ECB, took the following actions: It began open market operations buying government and private debt securities, reaching 219.5 billion in February 2012, though it simultaneously absorbed the same amount of liquidity to prevent a rise in inflation. It reactivated the dollar swap lines with Federal Reserve support. It changed its policy regarding the necessary credit rating for loan deposits, accepting as collateral all outstanding and new debt instruments issued or guaranteed by the Greek government, regardless of the nation's credit rating.
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 The move took some pressure off Greek government bonds Bond purchases on the open market provided liquidity to indebted sovereigns Long Term Refinancing Operation

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TIMELINE OF INTERVENTION

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The co-movement of national stock markets has long been a popular research topic in the finance literature (Makridakis& Wheelwright, 1974; Joy et al., 1976; Hilliard, 1979; Maldonaldo& Saunders, 1981; Phillipatos et al., 1983).
Early studies by Ripley (1973), Lessard(1976), and Hilliard (1979) generally find low correlations among stock markets, which validate the benefits of diversifications in international portfolio management. After the U.S. stock market crash in October 1987, the trend was reversed. Lee and Kim (1994), among others, find that national stock markets became more interrelated after the crash. Applying a VAR and impulse response function analysis, Jeon and Von-Furstenberg (1990) show a stronger movement among international stock markets after the 1987 crash.

European financial markets entered blockage in the last part of 2008, fuelled by fears of the banking systems exposure to the problems in the USA and the delay in adopting measures to support financial institutions.
The financial crisis spread rapidly to the real economy, as lending to companies and households dropped. 24

Transmission mechanisms presenting between returns and volatilities play a critical role in examining the distribution and interdependence across international financial markets
Firstly transmission mechanism is an indicator of market efficiency. If spill overs are found in return series then it is possible to exploit strategy profits which are against the market efficiency criteria. Secondly, it is acknowledged that information of return spill over effects is helpful to allocate assets and to construct portfolios. Thirdly understanding of volatility spill overs is crucial when dealing with those financial applications requiring for estimation of conditional volatility such as derivations pricing and value at risk (VaR) estimation. Tokyo and London stock markets and shows the transmission of volatility is asymmetric and is more pronounced when the news is bad and coming from either US or UK market. Kanas (1998) studies on the transmission effects among the London, Paris and Frankfurt stock markets and concludes that returns and innovations spillovers are higher during the post-crash time.
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Billio and Pelizzon (2003) obtain evidence showing that volatility spillover from the world index return series have increased after the introduction of the EMU (European Monetary Union) for most European stock market.
Christiansen (2007) investigates volatility spill over from the US and aggregate European asset markets into European national asset markets with the innovation of incorporating the bond markets into analysis. This study reports that significant volatility spill over effects widely exist and that the national bond and stock markets reciprocally influence each other. In addition to volatility spill over effects we look into conditional correlation as the second implement to study the dynamic linkages between the European and US markets. The simple and traditional method of measuring dependence is linear correlation (namely Pearsons correlation coefficient) because of its metric property of measuring dependence in multivariate normal distributions and, more generally, in multivariate spherical and elliptical distributions.
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SOME INTERESTING FACTS ABOUT EU

The World Competitiveness Yearbook ranked Austria No. 2 in quality of life, surpassing the U.S. and Japan.

According to the UN Human Development Index 2005, Belgium was the 9th most liveable country in the world. (one place ahead of the U.S.)
The Czech Republic has the largest number of incoming tourists per capita, with Prague being the most visited city. Finland is ranked as the most competitive economy in the world, ahead of the United States, according to the World Economic Forum. Germany has the worlds third largest and Europes largest economy. Germany leads the world in exports; 10.1% of world exports come from Germany. Forty-five of the top fifty multinational companies are present in Hungary
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Ireland is the world's biggest recipient of foreign direct investment dollars as a share of GDP. Italy is ranked as the worlds 6th largest industrial economy. According to the OECD, Italy's Gross Domestic Product (GDP at PPP values) is the sixth largest in the world. Luxembourg has the highest GDP per capita ($58,900) in the world. London has the world's largest foreign exchange market. The United Kingdom is the largest exporter to the United States and the largest recipient of U.S. investment in Europe. With less than 1 percent of the worlds population, the UK is responsible for 5.5 percent of global R&D. Bulgaria is second in the world in international IQ tests and SAT scores and fourth in the world in per capita university education after the U.S., Japan, and the United Kingdom.
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