Benefits of Common Currency

Name the key benefits of a common currecy

• Lower transaction costs

• Price Transparency

• Lower Exchange rate uncertainty

• benefits of international currency

• Monetary Union and Financial Stability

How are lower transaction costs a benefit

• eliminates need for forex markets

• countries benefit 0.25% to 0.5% of GDP

caveat to transaction costs

payment systems have to be fully integrated

How is price transparency a benefit

one unit of price facilitates price comparison - consumers shop around more - competition increases - prices decline consumers gain

Is there evidence of benefits of price transparency

no as price differentials still exist in EU, price convergence has not occured

How does lower exchange rate uncertainty help

one currency eliminates exchange rate risk

will welfare rise or fall under common currency

profits are higher under exchange rate and price uncertainty - if risk aversion among firms is high price certainty is preferred

Caveat to higher profit under higher exchange rate risk

• no adjustment costs

• no bankruptcy costs

how is seignorage a benefit

international markets hold euros in reserve

easy financing of government debt

How does monetary union effect LOLR

is easier as small countries have large fraction of liabilities and can’t provide as much liquidity to central banks as EU

Potential Caveat to ECB as LOLR

country can’t depreciate currency so may find it more difficult to get out of recession

What is the predicition of monetary union and economic growth

• lower real interest rate

• moves up production function more growth

What does evidence show of MU and growth

• major economies did not see the increase

• Catch up countries did e.g Ireland , spain

What does the analysis in Poole 1970 conclude

being a member of MU does not reduce systemic risk as the elimination of exchange rate variability leads to variability elsewhere

Caveat to Poole 1970

• assumed that randomn shocks stemmed from the goods market

What is the link in the literature between monetary unions and trade

benefits from monetary union will be large if economy is very open (large percentage trade of GDP)

Problems with simple model of Exchange rate uncertainty

• in model exchange changes normally distributed

• exchange rate changes are large and sustained often due to crises

• these are tail risks (with respect to normal distribution)

What are adjustment costs

• sharp changes in exchange rate result in higher cost for importers

• 1990s lira, devalued, became a source of competition for Germans and asymmetric shocks

Risk of seignorage

potential moral hazard due to uncontrolled borrowing

What is systemic risk

Systemic risk refers to the risk of widespread disruption to the financial or economic system as a whole,

In MU through which areas might the increased systemic risk seen in poole 1970 arise

output volatility (IS LM grpah explanation) , and Employment volatility

Summary on benefits of Monetary union graph main point

• larger and more open (more trade) countries benefit more

• The absence of MU creates larger exchange rate risk for firms in

Quick Money market argumetn summary

A monetary union may reduce exchange rate volatility, but it increases vulnerability to financial shocks, especially if there is no shared fiscal capacity or banking union.