Trade Creation/Diversion

&
Monetary Unions
Unit 13 - Lesson 8.2

Learning outcomes:
Explain the concepts of trade creation and trade diversion in a
customs union.
Explain that a monetary union is a common market with a common
currency and a common central bank.
Discuss the possible advantages and disadvantages of a monetary
union for its members.

Trade Blocs
When a Trade Bloc is created patterns of trade between countries change
and can:
1. Trade Creation: higher cost items within a country are replaced by
lower cost imported items from other members of the Trade Bloc.
2. Trade Diversion: when trade is diverted from a more efficient
exporter to a less efficient one due to the formation of a Trade Bloc.
a. Reason against Trade Blocs and for more Global Trade
Liberalization (WTO)
Trade Blocs do have the ability to improve Social Welfare and
Allocative Efficiency, but only if the gain is Trade Creation.

Summary chart:

http://image.slidesharecdn.com/internationaleconomiccooperation-2013-151202125820-lva1app6892/95/international-economic-cooperation-12-638.jpg?cb=1449061118

Monetary Union
Economic Integration by Monetary Union includes all the characteristics of Trade
Bloc, but takes it one step further.
The countries involved agree to:
1.
2.

Common Currency
Common Central Bank - Monetary Policy

Most common example is the European Union. In order to create the EU, the
countries involved had to agree to a number of requirements called convergent
requirements. These include:
1.
2.
3.

Limiting inflation
Limiting budget deficit to 3% of GDP
Limiting Government debt to 60% of GDP

Possible Advantages of Monetary Union

1.
2.

3.
4.

Single currency eliminate exchange rate

risk when trading.
Single currency eliminates any
transaction cost involved in dealing with
different currencies when trading.
Single currency allows for better price
transparency.
Single currency promotes greater
investment within the Union due to the
removal of currency fluctuation risk.
https://upload.wikimedia.org/wikipedia/commons/thumb/7/7d/Europ%C3%
A4ische_Wirtschafts-_und_W%C3%A4hrungsunion.svg/400px-Europ%C3%
A4ische_Wirtschafts-_und_W%C3%A4hrungsunion.svg.png

Possible Disadvantages of Monetary Union

1. Single currency causes a loss of exchange rate fluctuation which can
help exports.
2. Single currency causes those participating to lose the ability of using
Economic Monetary Policy to adjust the economy.
3. Any fiscal policy within a member country is restricted by the
convergent requirements.
4. Monetary Policy pursued by one central bank impacts the various
members differently and may help some while hindering others.