Currency Unions

National Bureau Of Economic Research Inc, Cambridge MA

Investigators

Abstract

Should each country have its own currency? Should one and only one currency circulate in each country? How many currencies should circulate in the world: 1, 10, 50, or the current number of roughly 180? These issues are at the forefront of the policy debate because of the politicoeconomic developments of the last few decades, which featured a large expansion of the number of independent countries. In 1947, there were 76 countries in the world; today there are 193 and, with few exceptions, all of these countries have their own currencies. Unless one believes that a country is by definition an optimal currency area, either there were too few currencies in 1946 or there are too many today. In fact, given the phenomenal increase in trade and financial integration between countries (the so-called globalization), one might have expected the number of currencies to decrease rather than increase in the post-World War 11 period. An additional pressure toward currency unions has come from the renewed emphasis on price stability, rather than active macroeconomic stabilization, as the main objective of monetary policy. This change in policy stance is likely a reaction to the inflationary decades of the seventies and eighties. As a result of these developments, the unquestioned identity "one-country/one-currency" is increasingly being called into question. This project studies, theoretically and empirically, the question of what is the "optimal number of currencies in the world." The basic strategy is to combine new economic analysis with two existing strands of the literature. One of these strands is the work on alternative exchange rate regimes and optimal currency areas; the second is the literature on formation of political jurisdictions and the equilibrium number of countries. The initial theoretical research shows how the benefits from currency union depend on trading costs, commitment abilities, co-movements of prices and outputs, accommodations of anchor countries to clients, and treatments of seignorage revenue. Further work shows how geographical considerations determine equilibrium configurations of currency unions. Further research includes empirical estimation of some of the key relationships in the theoretical framework, assessment of the sources of home bias in exchanges of goods and financial services, treatment of country size as jointly determined with currency arrangements, assessment of the interplay between currency union and financial development, analysis of underlying commitment abilities of policymakers, and more explicit allowance for competition among potential anchor currencies.