Currency Unions

I. Monetary systems around the world

II. Optimal currency areas
III. What changes with currency unions? Effect on
international trade
I Monetary systems around the
world

1) Common currencies. Examples

The Euro-12 currency union (will expand).
U.S. states, Panama & Ecuador & some other
small countries use U.S. dollar.
Currency unions of small countries: CFA franc
zone in Africa, linked to Euro; ECCA area in
Caribbean linked now to US dollar, before to
UK pound.
Consideration to unions in southern Africa,
Persian Gulf, Central America, Australia/New
Zealand.
I Monetary systems around the
world

2) Currency boards.
A currency board is a monetary authority that
issues notes and coins convertible into a
foreign anchor currency (also called the
reserve currency) at a truly fixed rate and on
demand.
A currency board can operate in place of a
central bank or as a parallel issuer alongside
an existing central bank; cases of parallel
issue have been quite rare, though.
Argentina worked well from 1991 to 2000,
then fell apart.
Others are Hong Kong, Lithuania, Estonia,
Bulgaria. Earlier, many British colonies.
I Monetary systems around the
world

2) Fixed exchange rates.

Link to outside currency or basket of
currencies provides nominal anchor. But
large devaluations and currency crises
sometimes occur.

3) Flexible exchange rates.

Monetary policy tied to domestic concerns,
e.g. price stability. Exchange rate freely
determined in exchange market. Exchange
rates are hard to predict. In practice,
countries intervene a lot.
I Monetary systems around the
world

Exchangerate regimes can then be

freely convertible or controlled.

Often
distinctions between legal
exchange rate and effective (black-
market) one.
 II Optimal Currency Areas
Recent trends
1) An increase in the number of small countries
In 1947, 76 independent nations in the world.
l In 2002, 193.

2) International trade has increased along time

This does not capture only the relabeling of trade
between united nations into international trade between
independent countries.

3) The number of independent currencies has increased

substantially
In 1947, 65 currencies
In 2002, 169 currencies.
II Optimal Currency Areas
Questions
l Is there any relationship among these facts?
For example, more nations can imply more
currencies and more trade.

l Related to this, we observe at the same time

that there is also a tendency nowadays toward
multi-country currency and trade areas.
l So, what is going on? Why might a currency be
a public good?
Theory on currency areas: Benefits
and Costs
1) Countries that trade benefit through specialization.
Therefore, if having common currency fosters
international trade, smaller nations should have more
incentives to get involve in a currency area.
2) For an inflation-prone nation, becoming a member of a
currency area can help achieve price stability. When
internal monetary discipline has not worked
historically, externally imposed discipline may do.
3) Union members lose monetary policy. In particular,
stabilization policy is no longer possible. (Some
developing nations are not good at stabilization policy
anyway.)
In this sense, countries with the largest co-movements of
output and prices with potential anchors are those with
the lowest costs of abandoning monetary independence.
In addition, similar price and output variances are also
good for joining the union.
Theory on currency areas: Benefits
and Costs
4) Trade, geography, and co-movements. Gravity models
say that distance and size explain well the ratio of
(exports+imports)/GDP. Distance and size in a wide
sense, including, among others, geographical,
linguistic, and cultural distances, and income and
population sizes.
Smaller distance may come with common shocks that
make output and prices to co-move. Hence,
countries that are closer have more incentives to
form a currency union.
However, if trade is inter-industry, nations may
specialize and, then, industry-specific shocks
become country-specific, thus causing less co-
movement of prices and output. Intra-industry
trade causes the opposite effect.
Which currency unions?
Theory predicts that nations that would
benefit the most from forming a currency
area or that are natural clients of a given
anchor are those that
1)Have no ability to commit to low
inflation.
2)Trade a lot among them or with the
anchor.
3)Have high price and output co-
movement among them or with the
anchor.
Empirical work on optimal currency
areas

Data:cross-country data on output,

price, bilateral trade, and bilateral
trade distance, from 1960 to
1997.
II Optimal Currency Areas
Conclusions about currency anchors
U.S. $ clients: Canada, Mexico, most of Central
America, parts of S. America (not Argentina,
Brazil), some Asia (Singapore, Hong Kong, S.
Korea).
Euro clients: Western Europe, much of Africa.
Eastern Europe? (missing data). Specific
examples, Morocco and Ireland are clear euro
clients, whereas Turkey and Israel are unclear
cases. Best anchor also for Ghana, Guinea Bissau,
and CAR but less clear for other African nations.
Yen clients: Japan is not an attractive anchor for
virtually anybody, maybe Indonesia. It never
appears in more than 1 criteria. Will China be
better for Asia?
II Optimal Currency Areas
Independent of any anchor: Australia,
New Zealand, India, China, Saudi Arabia,
UAE. Argentina, Brazil would be here
except for high inflation, which implies
demand for SOME currency union. Euro
looks a little better for them than U.S. $.

Other future currency areas?: Southern

Africa, West Africa, Central America,
Australia/New Zealand, Gulf States.
III What changes with currency
unions? Effect on international trade

On assessing the impact of sharing a

common currency on the volume of
international trade, a key issue is
causation. The reason is that trade also
affects the probability of forming a
currency area.
Rose (2000) and others used gravity
models augmented to include a currency
union dummy, and estimated large
effects. There is some ambiguity, but
most results are positive.
III What changes with currency
unions? Effect on international trade

Assumption in these studies is that

currency unions are randomly chosen,
i.e., there are exogenous. They may
suffer then from endogeniety problems
We know that theory suggests reverse
causation. More trade increases the
benefits of a currency union, and
therefore affects the likelihood of
countries forming a currency union.
[Aside: Also other problems may cause
bias, like omitted variables, sample
selection problems, nonlinearities, or zero
trade flows countries dropped.]
III What changes with currency unions?
Effect on international trade
Whats the solution? Instrumental variables.
They begin by looking for the determinants of
currency unions to find potential instruments:
i. Closer geographically
ii. Same language as anchor
iii. Former colony of the anchor
iv. Poorer in terms of per capita GDP
v. Smaller in terms of population size.

However, we cant use these determinants. They

are poor instruments because affect trade
directly.
 III What changes with currency
unions? Effect on international trade
Creating the
instrument
l Let p(h, e) be the
estimated
probability of a
currency union
between Honduras
and Ecuador. Its
value is obtain
using gravity-
model variables. In
particular, from the
regression:
III What changes with currency unions?
Effect on international trade

2) We can use the instrument

U(h, e) = p(h,US)*p(e,US) + p(h,Japan)*p(e,Japan)
+ p(h, Euro zone)*p(e, Euro zone).
It defines the probability that Honduras and Ecuador form
a currency union, indirectly estimated using potential
anchor nations.

3) The underlying assumption for the validity of this

instrument is that the bilateral trade between
countries Honduras and Ecuador depends on bilateral
gravity variables for Honduras and Ecuador, but not
on gravity variables involving third countries, notably
those associated with the potential anchor country.
Results:
(1) Effects are even larger. Currency unions seem to
have an important positive effect on bilateral trade.
(2) Table 10 also say that currency unions also raise
price (not output) co-movement between members.