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Can two countries share the same currency and both prosper?

Term Paper 2018 9 Pages

Economics - Finance

Excerpt

1. Introduction

This assignment will examine whether two countries can share the same currency and both prosper. In order to find out, arguments both in favour and in opposition to the research question will be discussed and evaluated. Finally, a conclusion will be drawn.

Before starting a detailed discussion, it is vital to establish precise definitions of the terms “sharing a currency” and “prosper”. For the purpose of this paper, “sharing a currency” is defined as being a member of a monetary union. According to Bergin (2008), a monetary union, also referred to as a currency union, is an association of at least two sovereign states which give up their national currencies to adopt a new shared currency. The author further states that by doing so, the member countries surrender their control over money supply as well as monetary policy to a shared authority, a new central bank. There are multiple currency unions all over the world, which is why, to apply this broad definition, this paper will use the Economic and Monetary Union (EMU) as an example. This specific monetary union was chosen due to its global uniqueness because, as Siklós (2009) notes, the EMU was the first currency union with both a shared currency and monetary policy but different national fiscal policies. The European Commission (What is the Economic and Monetary Union? (EMU), 2018) explains that the EMU was established in 1992 with the goal of increased growth and employment figures as well as overall enhanced economic stability. The common currency, the euro, launched at the beginning of 2002 and is used by 19 countries today (Euro area 1999-2015, 2018). Out of these 19, Germany and France will be analysed in this paper. These two countries were chosen because they are the two largest economies in the EMU, which should allow for some interesting examination (Share of Member States in EU GDP, 2017).

The second important term, “prosper”, is a little more difficult to define as there is a vast number of possible prosperity indicators, such as the unemployment rate or the wage level. For the purpose of this paper, “prosperity” is defined in accordance with Fritz and Koch (2016, p. 41) as the level of “economic development and material welfare”. Thus, if this level increases, prosperity in a state also does. Fritz and Koch (2016) argue that the higher the economic development in a country, the higher its individual and social prosperity. In order to gauge the level of prosperity of a state, a number of indicators are very useful.

One of the most important indicators for prosperity is the Gross Domestic Product (GDP) of a country. According to the Organisation for Economic Co-operation and Development (OECD) (Gross domestic product (GDP), 2016), the GDP indicates “the expenditure of final goods and services minus imports”. In addition to the GDP, the level of trade is an important indicator for a nation’s prosperity. As explained by the World Bank (Exports of goods and services (% of GDP), 2017), it is determined by the exports of both goods and services as a share of the respective country’s GDP.

2. Main discussion

Generally, there is much debate about the advantages and disadvantages of joining a currency union[1]. Most of them build on the most famous academic theory regarding this matter, the 1961 theory of optimum currency areas (OCAs) by Robert Mundell, for which he was awarded a Nobel Prize. His theory states that potential benefits arising from the membership in a monetary union, such as enhanced price transparency and lower transaction costs, have to outweigh potential detriments, such as giving up flexible exchange rates and sovereign monetary policy. In the following, these advantages and detriments will be discussed and evaluated.

The first argument in favour of prosperity as a result of a monetary union is the reduction of the transaction costs which arise from the exchange of currencies associated with the trade between different national currencies. This argument is brought forward by Brash (2000), Ca’Zorzi, De Santis, and Zamponi (2011) and Mundell (1961). Mundell especially stresses the importance of this argument, stating that the existence of a vast number of different national currencies results in the constant need to converse them. He believes that the high transaction costs resulting from these constant conversions of currencies essentially reduce the usefulness of money. Thus, Mundell concludes that by joining currency unions, the number of national currencies and, therefore, the transaction costs are reduced. According to the Commission of the European Communities (1990, p. 21), the savings made from lower transaction costs, in turn, reduce the “damaging impact on efficient resource allocation”.

Additionally, the savings can be utilised for other purposes, which is not only economically advantageous for businesses but also for governments and individual households. It is, however, extremely hard to measure the amount of these savings for France and Germany due to their different uses. Hence, the positive impact on prosperity of this argument cannot be quantified. Nonetheless, it is interesting to note that before the establishment of the EMU, the Commission of the European Communities (1990) conservatively estimated that the overall transaction costs of the European Community[2] amounted to approximately 13 to 19 billion euro per annum. Given the significance of this amount and the above mentioned position of France and Germany as the two largest economies in the EMU, it is obvious that their trade levels are equally large. Consequently, they enjoy great transaction cost savings as a result of their participation in the monetary union, leading to increased prosperity.

A second major argument in favour of the research question is that participation in a currency union increases trade levels. Brash (2000) argues that by joining a monetary union, the exchange rate uncertainty arising from trade with different countries is eliminated. Accordingly, he finds that a monetary union stimulates internal trade between the members and yields prosperity in the form of productivity gains. This conclusion is shared by Ca’Zorzi, De Santis, and Zamponi (2011), who agree that a currency union substantially improves trade between its member states. Rose (2000, p. 31) delivers solid empirical evidence for this argument, calculating that countries in monetary union trade “over three times as much as countries not sharing a common currency”. Baldwin et al. (2008, p. 9) confirm that this more than 200% trade increase is the result of robust calculations and apply the so-called “Rose effect” to the case of the EMU. They prove how the euro, only six years after its launch, led to a significant increase of trade of approximately 5% among the countries using it as their shared currency. Following these findings that a currency union leads to prosperity through increased trade levels, Frankel and Rose (1998) add that states with close trade links and high trade volumes benefit more from joining a monetary union. According to the authors (1998, p. 1009), it makes these states “more likely to be members of an optimum currency area”.

Alesina, Barro and Tenreyro (2002) take into account sensible prevalent expectations regarding substitution and elasticity between different goods and agree with Frankel and Rose (1998) that nations which already trade great volumes with each other also stand to gain a great amount from sharing a common currency. In his context, Brash (2000) notes that upon foundation of the EMU, intra-union trade between the future monetary union members already accounted for a very high proportion in most of these countries. This included France and Germany, which, therefore, were in an excellent position to receive the prosperity gains from the increase in trade mentioned above. According to Rose (2000), these gains from trade are a result of the increase of competitive pressures and they can be considered as quite substantial. This assumption is confirmed by empirical results from Frankel and Romer (1999), who conclude that trade indeed raises income. The authors (1999, p. 394) find that “a rise of one percentage point in the ratio of trade to GDP” results in a 0.5% to 2% increase of the income per person. Adding up the 200% trade increase and the at least 0.5% income increase per one percentage point trade increase, it becomes clear that the establishment of a monetary union leads to enormous prosperity gains for its participants, including France and Germany.

A third argument in favour of prosperity as a result of sharing a currency is the abolishment of flexible exchange rates. According to Bean (1992), the pre-EMU system of slightly flexible exchange rates for all currencies within the European Community was not viable in the long term perspective. In his opinion, inevitable economic or political tensions would have had destructive influences and, thus, the only feasible long term alternative was the establishment of a currency union with a single currency. Ca’Zorzi, De Santis, and Zamponi (2011) share this view and agree that flexible exchange rates lead to instability. The authors argue that the removal of said flexible rates through participation in a monetary union leads to greater stability and the elimination of currency risk. They believe that this, in turn, leads to enhanced financial integration, which may reduce financing costs of businesses, again leading to enhanced prosperity.

Altogether, lower transaction costs, increased trade and enhanced financial integration all contribute to increased long term prosperity of the countries sharing a currency in the form of a monetary union.

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[1] See McKinnon (1963); Kenen (1969); Alesina, Barro and Tenreyro (2002)

[2] Member states of the European Community (now European Union) in 1990: Germany, France, Italy, the Netherlands, Belgium, Luxembourg, Denmark, Ireland, United Kingdom, Greece, Spain and Portugal (Europe without frontiers, 2018)

Details

Pages
9
Year
2018
ISBN (eBook)
9783668795914
ISBN (Book)
9783668795921
Language
English
Catalog Number
v437651
Institution / College
University of Strathclyde – Business School
Grade
1,7
Tags
Currency EU European Union Euro Currency Sharing Financial Markets Prosperity Monetary Union European Economic and Monetary Union Economic and Monetary Union GDP

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Title: Can two countries share the same currency and both prosper?