MONETARY UNION: Introduction

This paper explores the gains to monetary union. While the adoption of a common currency will soon be a reality for much of Western Europe, understanding the motivation for a monetary union and designing optimal monetary and fiscal arrangments within such a union remains an open challenge to economists.

The relatively informal debate on monetary union has identified a number of potential gains. Following the European Commission’s 1990 report on a common currency in Europe (Emerson et al. [1992]) it is convenient to focus on two types of benefits: efficiency and stability.

Within the first category, the European Commission, as well as numerous other economists, emphasize the savings of transactions costs under a common currency system.1 The Commission’s report estimates these gains at nearly 0.5% of European Community GDP. Apart from these direct savings, it is also argued that there are farther gains from a more efficient price mechanism, increased competition and larger, more integrated markets. Included in the second category is the stability of prices and output. In particular, the aims of reducing the levels of both inflation and unemployment as well as their variability are identified in the report.

One of the goals of this paper is to evaluate these arguments in favor of a monetary union within a dynamic general equilibrium structure rather than the traditional model of currency areas.2 As noted by Wyplosz [1997], from the perspective of the traditional Mundell-McKinnon-Kenen model of optimum currency areas, ”… the case for Europe as an optimal currency area is lukewarm at best.” Our model departs from the traditional approach by allowing private agents and their governments to act optimally. Further, we study an overlapping generations model in which all markets clear as prices are fully flexible. Despite this discipline, we do find that there are some welfare gains to monetary union which, given the structure of our model, we are able to completely characterize.

The model we study in this paper indicates two key gains to monetary union which parallel the informal arguments advanced by the European Commission. First, as suggested by the commission, the adoption of a single currency reduces the frictions associated with the flow of goods across countries. In our abstract formulation, these gains arise from the inability of agents to costlessly respond to specific changes in their tastes for goods in a multi-currency world (studied in Section II of the paper). The adoption of a common currency thus facilitates the response of agents to these individual shocks and, in equilibrium, leads to a more efficient allocation of goods. We view this result as representing the welfare gains associated with reducing trade frictions created by the presence of multiple currencies.

Second, our model highlights the price stability benefit of monetary union from the centralization of monetary policy. In a world with multiple independent currencies and local currency cash-in-advance constraints, governments maximize national welfare by creating excessive inflation. payday loans no checking account