Examine the benefits and costs of two or more countries sharing a common currency, and comment on the impact of the ‘one size fits all’ monetary policy of the Eurozone. Normally, the accumulation of a set of countries accepting a specific common currency is known as a monetary union. This involves the countries becoming part of the same trading bloc and accepting free trade policies between the member countries. Since the focus of the question is centrally revolved around the monetary union, the other aspects of the union will not be considered in detail.
Naturally, the prime example to use when discussing the use of a common currency is the European Monetary Union. Launched on January 1st 1999, the union boasts a 16 country agreement to use the same currency- the euro. For countries to merge by a single currency requires the merging countries to meet certain criteria. This obviously brings both benefits and costs to the table. Benefits are associated with higher stability of the union as only those countries that meet the minimum requirements can join.
This allows the union to ensure that the countries that join add something to the union and add value to the currency. For example, conditions in the European Monetary Union state entrant countries must have interest rates within 2% of the 3 lowest interest rate countries in the EMU and also have inflation within 1. 5%. This is important because if we take a scenario where the inflation rate is excessively high in a country, then this will affect the value of the currency by devaluing it.
This devaluation has clear knock on effects as the devaluation will cause the cost of imports to rise. Domestic consumers will also shy away from domestic consumption as they see the high prices and so they will shift their consumption on consumer durables from other countries. Exports would be heavily affected by this scenario as the foreign countries would see the high prices associated with the importing of the goods and shift their interest into consumption from countries with lower relative price levels.
Not only does the high inflation associated with the currency affect consumption but also investment. The unstable level of inflation will deter foreign direct investment and also reduce the net domestic investment as the returns to the investment would have a high risk associated. So obviously having specific criteria that member countries must meet help to ensure stability in the union. The negative associated with having these criteria is the one size fits all policy which will be discussed later. There are many costs and benefits associated with having the same currency.
There is a key advantage to consumers and residents in the country of having the same currency. The transaction costs associated with exchanging the currencies is eliminated. This means that if domestic consumers were to travel abroad to countries within the monetary union, the identical currency would enable them to spend abroad without the need to swap currencies. This advantage is more of a social benefit as this would reduce stress to the consumer. This is because the consumer would not be worrying about if their money would arrive on time.
Also the excess commission associated with changing the currencies is eliminated. Although again this commission only represents a small amount of GDP the advantage is again a social benefit as the consumer escapes the hassle associated with the exchange of the currency- often quite a stressful factor when planning to travel. There is also a benefit associated with price transparency where if the same good is sold in many of the countries in the monetary union, then it is easy for the consumer to compare prices. This should reduce price discrimination and increase competition.
This is a healthy scenario for the consumer as they would benefit from price competition- often the price of the good or service falls. Despite this potential benefit there is evidence that this is not the case and that price differentiation exists- an example being price differences within member countries in the EU. The same currency and stability associated with the monetary union encourages transnational companies to invest. This is because there would multiple countries across the zone to invest in and get returns from as they all follow the same currency and would all be under the same central control.
This may help the multi-national countries achieve greater economies of scale as there would be easier trading and investment capabilities across the zone. This would lower average costs for firms and increase the relative GDP in the zone. This would increase economic growth. Therefore having the same currency enables economic growth in a country through increased business confidence as there is increased stability. The drawbacks of using the same currency are also quite evident. The main and key drawback is the ‘one size fits all’ policy. Here the monetary policy is controlled by the central bank.
Countries have no ability to set the interest rates in the country. This can be disastrous in a country with low consumption or investment levels. This is because if the central bank placed high interest rates on countries within the union, consumption would be further detracted, leading to a drop in economic growth. Therefore the loss of individual control is a major factor that needs to be considered before becoming part of the same currency. There can also be a case where the central bank will set interest rates that accommodate the larger, higher productive countries in the union.
This will mean the smaller countries will grow at a slower rate and potentially lead to greater inequality. The one size fits all policy may mean that the union becomes less flexible and therefore the policies can place constraints on economic growth for countries. This can cause inefficiency as the production will not be at optimum potential and will limit countries. Another huge drawback is the effective exchange rate differences would be eliminated. For example, during the economic boom of the early 2000’s, England had a very strong exchange rate compared to the other European countries.
This enabled cheap imports for the country, increasing domestic consumer welfare. By switching to the euro, the imports would not have been cheaper and would have left consumers with a drop in welfare as they would not have been gaining through a stronger exchange rate. Overall the costs of switching to the same currency have its drawbacks outweighing its benefits. This is especially the case for the one size fits all policy as this is the policy that loses the country its individuality and means the country loses control of its monetary policy.