Monetary Union | 1st Class Economics

Monetary Union. A monetary union is a group of economies sharing the same currency. One central bank controls the currency, monetary policy and exchange rate policy for all the members.

In the European Monetary Union (EMU), the European Central Bank (ECB) controls monetary policy and exchange rate policy for euro members.

Each euro member has independent fiscal policy but there are rules over how large fiscal deficits can be. The rules of the stability and growth pact mean euro members’ fiscal deficit cannot exceed 3% of GDP and national debt cannot exceed 60% of GDP.

Benefits of the EMU

Lower transaction costs. Transaction costs are the costs of trading currencies. In the EMU, all euro member share the same currency the €. An agent in one member country can buy from a firm in another member country with the same currency. Agents do not need to change their currency to buy from a member country so there are no charges or commission. However, transaction costs may be very small.
Lower exchange rate risk. All euro members share the same currency the € so there is no risk that one member’s exchange rate will change. This makes it easier to plan and easier to invest in each country. But, firms that exist to speculate in currencies will be harmed.
Multinational companies. Multinational companies may set up in member countries because it could be more profitable to invest and trade in a monetary union. Members share the same currency so there are no exchange rate fluctuations between members, it is easier and less risky to plan and invest. Transaction costs, tariffs and quotas are reduced or removed so it is more profitable for multinational companies to produce and sell output within the monetary union.
Price transparency. All countries sharing the same currency means agents can easily compare prices between member countries and buy goods at the lowest price. This also makes it harder for multinational companies to price discriminate by charging higher prices in some member countries than others for the same good. However, there is still evidence of price differences between euro members. Resultantly, consumer surplus rises and firms become more allocatively efficient as prices move closer to P=MC.
Economies of scale. A monetary union means trade barriers between members are reduced or removed, so trade between members should rise. More trade means more can be produced, giving members the opportunity to benefit from economies of scale. Members’ firms could then become more allocatively and productively efficient.
Macroeconomic management. The ECB, who control the currency and monetary policy for all members, may provide sounder macroeconomic management than the domestic central banks of the member countries. The stability and growth pact should also mean that euro members do not build up too much debt.
Lower risk premiums on interest rates. Members of a monetary union may be deemed less risky to lend to by international creditors. Members’ credit worthiness rises and they are charged lower risk-premiums on interest rates when they take out international loans. But, given the 2011/12 euro debt crisis, it is now more risky to lend to any euro member as the future of the euro is uncertain, so euro members may now face higher interest rates on foreign loans.

Costs of the EMU

Transitional cost. All new euro members must change their currency to the € so they must adjust their prices to the €, this involves costs because money, menus, catalogues, websites and shop signs must all be changed. But, if a country is experiencing high inflation then it will have to change its menus and websites anyway, adding a € symbol will not be that much more costly.
Loss of independent exchange rate policy. Because the ECB controls all euro members’ exchange rate, members lose control of their own exchange rate so members cannot manipulate their own exchange rate to affect their current account, AD and real GDP. However, a country may not be able to devalue its currency anyway because other countries will retaliate by devaluing too.
Loss of independent monetary policy. Monetary policy is no longer under the control of each euro member’s domestic central bank. The ECB controls monetary policy for all euro members. One euro member may need to use loose monetary policy to boost AD and real GDP but all other members may need a tight monetary policy to reduce AD and inflation. Members do not control their own monetary policy and so the monetary policy set by the ECB for the majority of the Eurozone may be unsuitable for some particular members.
Business cycles. Business cycles may not have converged between members. Some members may be in a boom whilst others are in a recession. This requires the opposite types of monetary, fiscal and exchange rate policies for each member.
Loss of political sovereignty. Members may be forced to trade with countries they wish not to trade with.
Restrictions on fiscal policy. A euro member may need to use expansionary fiscal policy to boost AD in a recession but the stability and growth pact’s 3% fiscal deficit rule will restrict the ability of a country to use fiscal policy. AD may remain too low and the economy may remain in a recession. But, France and Germany broke this rule in the early 2000s with no repercussions so it may not really restrict fiscal policy.
Loss of national sovereignty. Members do not have separate currencies so lose some of their national heritage. Money is usually illustrated with each country’s famous heroes, in a monetary union all members have the same currency though so no national heroes can be printed on them.