Currency unions, monetary unions

A currency union (also known as a monetary union) is a group of countries that use the same currency. They also have the same central bank that issues the common currency. The most prominent example of this arrangement is the European Monetary Union where almost half the European countries use the euro. Originally these countries had their own currencies such as the Deutsche Mark in Germany and the French Franc in France. In 2001 they replaced these moneys with the euro.

You may not realize that the United States is also a currency union using the dollar for transactions across all states and territories. That was different in earlier times when several currencies circulated alongside each other. Other examples are the monetary union among some Caribbean countries using the East Caribbean dollar and the CFA zone that combines several African countries.

The benefits of currency unions

There are important advantages to using the same currency across countries. On a personal level, travel and cross-border shopping is much easier if one does not need to exchange currencies. Imagine, for example, that going on a holiday from New York to Florida required exchanging NY dollars for FL dollars. Should you buy FL dollars now or right before you leave? How much should you buy? How can you avoid the commissions for currency exchange? Clearly, this is a hassle that is eliminated when New York and Florida use the same money.

The same advantages apply to companies. They don't have to spend money to convert currencies and they don't need to worry about the future value of various currencies. They also don't need to spend money and effort to hedge, i.e. to protect themselves from currency changes. As a result, businesses can trade and invest across borders more easily. This leads to more international investment and more international trade which, ultimately, leads to stronger economic growth and greater prosperity.

The costs of currency unions

When several countries use the same currency and investment moves between them without restrictions, then their interest rates become similar. To see why, let's say that French banks offer higher interest rates on deposits than Italian banks. In both countries the deposits are in euro and the risks are the same. Then, people who have money will move their savings from Italy to France. This will lower interest rates in France and will increase them in Italy, until they are equalized.

Having the same interest rates could be a problem. We can continue the example to see why. Let's say that the Italian economy is in a deep recession with high unemployment while the French economy is overheating and has high inflation. Then, we would like to have low interest rates in Italy to stimulate the economy and high interest rates in France to slow down the economy. However, with a currency union the interest rates in both countries are the same. As a result, the unemployment in Italy and the high inflation in France will continue.

At some point the countries may decide that the "one-size-fits-all" policy does not work for them and that they are better off on their own. The union then collapses.

When does a monetary union work well?

If Italians cannot find work whereas Ireland offers many employment opportunities, then the unemployed Italians could move to Ireland. Then, the unemployment rates in both countries will become similar and it would not be a problem to have the same interest rates and the same monetary polity. Therefore, easy migration helps.

Alternatively, Italians could accept lower wages that could help reduce production costs in Italy. Italian exports will increase and the Italian economy would recover. In other words, wage flexibility could also help.

Finally, the Irish may collect more taxes and transfer money to the Italians to pay for social programs and unemployment benefits. That may also stimulate the Italian economy as it puts money in people's pockets and leads to more purchases of goods and services.

Optimum currency areas

If a group of countries satisfies at least some of the criteria outlined above, then we say that they form an optimum currency area. In the U.S., for example, people can and do move between states and cities with ease. There are money transfers between states through the federal government.

In contrast, in Europe people can but do not move to work and live in other countries very much as there are language and cultural barriers. The European governments are very reluctant to spend money on other countries. And it is fairly difficult to lower labor costs that are bound in collective contracts. Europe has to either make changes in these areas or risk losing the euro.

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