Monetary Union – Diagrams, analysis and evaluation

A monetary union is a group of nations sharing the same currency.

The Eurozone is one example of this. This is a group of 20 countries that share the euro as its currency.

Note the European Union is not the same as the Eurozone. The European Union (EU) is a single market – a trading bloc with no trade barriers and free movement of factors of production. The EU includes more countries. For example, Denmark is in the EU but not in the Eurozone, as it has its own currency.

Another example is the West African monetary union. This group of countries includes Mali, Senegal and Benin. They share the CFA Franc as their currency.

A-level Economics Resources
A-level Economics Notes

Contents

Advantages of monetary union

1. Reduced costs of currency conversion. To trade between members of the monetary union, there is no longer a need to convert currencies. So businesses do not have to pay fees to exchange currencies. Also businesses do not need to pay for “forward contracts” to protect themselves (“hedge”) against the risk of currency fluctuations. This reduces business costs, so businesses see higher profits and may invest more. They may also be higher foreign direct investment from other countries within the bloc as a result of higher currency certainty. This will also boost trade flows between monetary union members.

2. Greater price transparency. It is easier to compare prices in different countries. This is likely to increase competition between firms. So this reduces prices for consumers and increases the quality of products. So consumer welfare increases.

3. Countries in the monetary union cannot keep inflation low or maintain international competitiveness by manipulating the currency value. So they have the incentive to increase productivity and incentives not to run budget deficits, to keep inflation down. In other words, by not being able to control monetary policy, it disciplines countries to have the other necessary policies to keep inflation low.

Disadvantages of monetary union

1. Each country no longer has its own currency. So a country in a monetary union cannot devalue its currency to restore competitiveness. The ability to do this lies with the central bank of the monetary union. Economies like Greece saw rising wages and prices relative to other Eurozone economies in the 2000s. This pushed up Greek unit costs (average costs), reducing competitiveness. To restore competitiveness, they cannot devalue their currency (a relatively painless and quick way to restore competitiveness). Instead, they had to lower wages and prices through contractionary fiscal policy. This may generate a downturn and is a much more painful way of restoring competitiveness. Indeed youth unemployment reached 50% in Greece in the early 2010s.

2. Joining a monetary union means delegating monetary policy to one central bank in the monetary union. In the Eurozone, this is the European Central Bank (ECB). The ECB may use policies that are inappropriate for particular countries. For example if the bloc is in a boom overall, the central bank raises interest rates to control inflation. But if only one country is in a downturn, then raising rates will make the downturn worse.

3. Having a new currency brings extra costs, though these costs are likely to be one-off. Businesses have to update prices to be in the new currency and inform consumers.

Diagrams

Reduction in business costs

A reduction in business costs occurs because of lower currency conversion costs. This shifts aggregate supply to the right from AS to AS1. So real GDP increases and the level of inflation falls.

Monetary policy in a monetary union

If the European Central Bank raises interest rates, this reduces aggregate demand. This leads to lower inflation. But what if different countries are at different positions in their economic cycles?

Suppose a country like Germany is in a boom at AD1 with high price level PL1. But another country like Croatia has aggregate demand at AD. So it operates at the full employment level of output YFE.

Now if the ECB raises interest rates, this moves Germany from AD1 to AD, restoring full employment. But for Croatia, it moves from AD to AD2, triggering a downturn.

Evaluation points

The success of a monetary union depends on:

  • Reliance of firms on imports. Suppose a country is very self-reliant, so it does not rely much on imports. Then there is not as much benefit from eliminating currency conversion costs.
  • Percentage of trade conducted with members of that monetary union vs other countries. For a monetary union to reduce currency conversion costs more significantly, a larger proportion of trade should be with members of the monetary union.
  • Whether members of the monetary union have aligned their economic cycles. Aligned economic cycles means monetary policy is more likely to be appropriate for each country. The problem of asymmetric shocks is less likely. Indeed before joining the Eurozone, one of the conditions (“convergence criteria“) for joining is to have an aligned economic cycle with other member states.
  • The budget deficits of member states. Ideally, member states would avoid significant budget deficits before joining. As monetary policy is delegated to a central bank, countries need to have fiscal room to use expansionary fiscal policies if necessary. This is again one of the convergence criteria that countries must meet before joining.
  • The ability of member states to transfer funds between themselves. In other words, whether there is “fiscal union“. Fiscal union can help smooth out asymmetric shocks. For example, suppose one country faces a recession and cannot use expansionary monetary policy, as it is part of the monetary union. Then other regions can send fiscal transfers (funds) to that region to help it recover. But this can prove controversial.

To view more A-level Economics resources, check out these links below:

A-level Economics Practice Papers
A-level Economics Notes
Economics Resources for A-level

Latest posts

About the author

Tom Furber

Helping economics students online since 2015. Previously an economist and economics tutor, I now focus on providing economics resources on tfurber.com. Read more about me here.