Currency Union: Definition, Pros & Cons

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Sharing a common currency and monetary policy can create many benefits for the citizens and businesses of a currency union. They also can create thorny problems. Let's explore what a currency union is and its consequences.

Money Problem

Imagine you live in the United States and you are about to take a long road trip. You will go to many different states and see and do many interesting and fun things. You don't give any thought to the currency you will need because the U.S. dollar is accepted in all 50 states.

If you lived in Europe before 2002 and wanted to take that same kind of road trip, it would have been different. You would have needed a different currency for every country you planned to visit, such as French francs, German Marks and Italian lira, just to be able to pay for gas and food. There has to be a better way, right?

What Is a Currency Union?

In a currency union, two or more countries share one currency or agree to fix their exchange rates at a certain level. Using the same currency (money) is easily understood. Fixing exchange rates isn't difficult either. Let's say the U.S. and Canada agreed to make one U.S. dollar equal to one Canadian dollar. That would be fixing the exchange rate instead of letting it go up and down all the time like it does now.

Currency unions are also known as monetary unions. The goal is to synchronize monetary policy and manage it centrally. So not only do participants use the same currency, but they let one central bank manage the currency and monetary policy for all of the countries.

Currency unions have been around for a long time. The first step in uniting the states of the old German Confederation was to standardize coin values. The currency unions that formed in the 1800s made travel and trade easier and were popular with the people and businesses. The United States did not have a common currency until 1863 when the dollar was officially adopted.

Symbols for the U.S. Dollar and the Euro
Currency

The largest and most well-known monetary union is the European Monetary Union. It started in 1998 when the European Central Bank was created to oversee the fixing of exchange rates. In 2002, 12 countries took the big step and solved our traveler's problem, as well, by adopting a common currency, the Euro. Today it is the currency in 19 European countries.

Benefits of Monetary Unions

What are the benefits of forming a monetary union? Let's look at some major ones:

  • It facilitates the movement of people. Things are a lot easier now for our traveler without worrying about currency conversion. It's not only easier to travel, but the common currency facilitates labor force mobility. Jobs in any country that use the Euro can be compared now since they all pay in the same currency. Citizens will find it easier to seek jobs in other countries.
  • It facilitates trade and the movement of goods. Let's say you are a wine merchant in France. If you wanted to sell your vintage in other European countries, you needed to price it in all of the different currencies, which is a lot to keep up with. With a common currency, you can just price it at, say, 10 Euros per bottle and sell it anywhere on the continent!
  • It reduces business risk. Our wine merchant used to face business risk from currency fluctuations. Say the French franc was worth one German Mark. After an economic calamity, it is now worth two German Marks. The merchant could either double his price to keep up and lose sales, or suffer reduced revenue. Neither of those is an appealing choice. Common currencies and fixed exchange rates eliminate this problem because there are no more currency fluctuations.

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