Monetary Union

Updated on February 7, 2024
Article byKhalid Ahmed
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Monetary Union?

A Monetary Union or common currency zone refers to an intergovernmental agreement where a single monetary policy and currency prevails and circulates freely. It aims to act as a fixed-exchange-rate system, eliminating the risk of unexpected exchange rate movements and promoting international trade between member nations of the union.

Monetary Union

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It increases trade between nations smoothly and transparently. It allows for easy price comparisons between nations, encouraging competition while lowering costs. In addition, reducing the total transaction cost and increasing the cost savings are some benefits of monetary union. Also, member nations can have enhanced monetary policy coordination with each other.

Key Takeaways

  • A monetary union, often known as a common currency zone, is an arrangement between governments in which a unified monetary policy and freely circulating currency are in place.
  • It attempts to function as a fixed-exchange-rate system, removes the possibility of unforeseen fluctuations in exchange rates, and encourages trade between union members on a global scale.
  • It eliminates exchange rate ambiguity and currency conversion costs but limits autonomous monetary policy implementation.
  • It entails shared currency and policy, while an economic union permits cross-border trade, whereas a customs union eliminates internal tariffs among member nations.

Monetary Union Explained

A monetary union definition entails many countries ceding their control over the money supply to a single authority formed by the representatives of member nations. However, for it to succeed, it needs strong coherence of ideas and cooperation between member nations, without which the union might fail to work or implement any positive changes.

The most important aspect of a union contributing to its work is the convertibility of currency throughout the union—externally and internally. Only then is the value of the union and seamless transactions between nations possible. Moreover, it requires a more explicit institutional framework, giving the central bank the desired independent tools, power to maintain the stability of the common currency, and authority to stop direct state funding and mitigate any unwanted monetary expansion in the region.

In addition to that, a currency union has the following characteristics:

  • It must have a single currency or multiple currencies that are convertible entirely at fixed exchange rates, immutably. Therefore, it does not allow any national autonomy concerning monetary policy due to an arrangement where a monetary union determines the monetary policy of every nation.
  • Despite benefits, these unions pose issues at the supranational and national levels. They have to respect national sovereignty while preparing a unified monetary framework and coordinating macroeconomic policies. In other words, they make sure to function within the realm of the decentralized economic policies of member states. For that, it has to adhere to standard fiscal rules and policy coordination.
  • Above all, they also present benefits like streamlining transactions across the borders of member nations, offering price transparency, and may even enhance market rivalry, leading to affordable goods benefiting customers. However, in the financial world, it exemplifies the intricacies of merging economies within a currency, like the Euro in the Eurozone.

Examples

Let us understand the topic by studying one of the monetary unions, the European Monetary Union.

Example #1

On October 27, 2023, the members of the Euro Summit were held, where they discussed that effective coordination of national fiscal policies is crucial for the Economic and Monetary Union, the entity trying its best to have a strong single currency policy, ensuring stability and resilience for the euro area and the EU. The summit, however, primarily focused on the financial and economic situation of the European Monetary Union.

They also addressed ongoing initiatives in the European capital and financial markets through funding unlocking, leadership, and increased private-sector investments. In addition to that, the banking union has strengthened and stabilized the EU banking industry, giving it substantial capital and liquidity positions, thus helping in economic integration and boosting trade, leading to the growth and development of its members.

Example #2

Suppose states Cascadia and Alleghenia of Greenasia formed a monetary union in 2023. It aimed at streamlining the economies of the respective countries. During the first quarter of 2023, Cascadia increased its exports to Alleghenia to five hundred million dollars. Allegheny got its manufacturing sector to export to Cascadia, reaching $350 million dollars.

However, during the third quarter:

  • In Cascadia – Alleghenians spent $90 million on tourism.
  • In Alleghenia – Cascadian visitors spent $120 million on tourism.

As a result of the union formation, the economies of these two nations integrated, leading to enhanced trade and promoting unprecedented economic growth and cultural exchange between the two nations.

Advantages And Disadvantages

Due to political and climatic changes, it has become essential to ensure smoother business. However, it has certain shortcomings, as discussed in the table below:

AdvantagesDisadvantages
Monetary unions eliminate exchange rate ambiguity and the costs of currency conversion by using a single currency.It limits the devising and implementation of autonomous monetary policy.
Businesses and nations can trade easily with transparency amongst each other using a common currency.Imposes restrictions on fiscal policy on member states, like budget deficits and public debt.
It boosts trade between member states. Economic downturns may have different levels of effects on participating nations.
It reduces transaction costs among members during trade.It requires solid political will from every member nation; otherwise, it may destabilize because of tensions and conflicts.
Coordination and monetary policy are enhanced.A high degree of political integration is required.
It gives access to larger financial markets.It tends to fail at times.
Indirectly benefits economic growth.Fiscal discipline is needed.

Monetary Union vs Economic Union vs Customs Union

Every type of union contains implications that impact the member states’ policies and economies, as per the table below:

Monetary unionEconomic unionCustoms union
A region having shared currency and monetary policy.Only allows free cross-border trade.It is a group of nations removing all internal tariffs.
Coordination of economic and fiscal policy is a must.Integration of fiscal and monetary policy is required.There is no need for the integration of monetary and fiscal policies.
A primary currency is either a perfect substitute or a unified currency.It uses a common currency traditionally.A common currency is not required.
Reduces transaction costs and increases trade.Workers, services, and goods move freely across the member states.No tariffs are imposed within the union.
It leads to price transparency and economic integration.It encourages free trade without tariffs.Offers uniform policy and zero internal tariffs toward non-members 

Frequently Asked Questions (FAQs)

1. What is the currency of the European monetary union?

For the integration of European economies, a significant step was taken in the form of the Economic and Monetary Union (EMU). It was created in 1992, comprising coordination of fiscal and economic policies, a unified monetary policy, and a single currency called the EURO.

2. What does the European Monetary Union do?

First of all, it created a common trading area called the Eurozone with a single currency. This reduced transaction costs between the member states, and it increased regional competitiveness and market efficacy. Thus allowing more straightforward trade between the member states.

3. How many monetary unions in the world?

Informally or formally, there are sixteen currency unions worldwide. The European Monetary Union (Euro) and the Compact of Free Associations (US dollar) are the two biggest unions among them.

This article has been a guide to what is Monetary Union. We explain its examples, advantages, disadvantages, and comparison with economic and customs unions. You may also find some useful articles here –

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