Monetary Union

A monetary union is defined in general as two or more otherwise independent states joining together to share a common currency. Traditionally, sovereign states have issued their own currencies for both domestic and international exchange. Nevertheless, in the past, countries have elected to join together in some sort of monetary union. There were repeated attempts to establish monetary unions in Europe during the 19th century.

There are two broad classifications of monetary unions. In a “shared” type of union, the members are part of a de facto equal partnership in that each relinquish their own currencies for a single joint currency and they share authority in decisions affecting the union's monetary affairs. In the case of a “surrendered” union, the partnership is fundamentally unequal, with the subordinate partner(s) agreeing to convert their own currencies for that of the dominant member. In this case, the latter country tends to dominate in decisions affecting monetary matters for the group.

It is generally true that realization of a monetary union is a major step in the evolution toward, although it in no way implies the préexistence of, a full political union. Typically, however, states that come into a monetary union have already achieved the status of a common market, although there is no requirement that this be the case.

The most significant advantages of a monetary union include (1) elimination of currency exchange transaction costs, thus reducing the costs of doing business internationally; (2) removal of currency volatility and thus currency exchange risks for companies operating in the member countries because there is a single currency in which to conduct business; (3) greater competition because of the greater transparency in comparing prices of different products and services across the union, and thus greater efficiencies and lower prices; and (4) financial economies of scale due to the creation of a single currency capital pool for members to use in common, thus allowing all members expanded opportunities to access a greater volume of cheaper capital as well as a wider range of investment options.

An important disadvantage of a monetary union is that national governments sacrifice control over monetary policy and thus the leverage to act unilaterally to deal with their particular country's financial crises. This is a particularly critical problem if the members making up the union do not constitute an optimal currency area, i.e., the underlying structure of economic and financial activity within each country is unique and significantly different from one another. In this case, monetary policy conducted by the union's central bank may help one member while damaging the economies of others. Lowering interest rates may help boost a stagnating economy but, at the same time, is just as likely to overheat an already growing country.