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A currency union (also known as monetary union) is an intergovernmental agreement that involves two or more states sharing the same currency. These states may not necessarily have any further integration (such as an economic and monetary union, which would have, in addition, a customs union and a single market).

There are three types of currency unions:

The theory of the optimal currency area addresses the question of how to determine what geographical regions should share a currency in order to maximize economic efficiency.

Advantages and disadvantages

Implementing a new currency in a country is always a controversial topic because it has both many advantages and disadvantages. New currency has different impacts on businesses and individuals, which creates more points of view on the usefulness of currency unions. As a consequence, governmental institutions often struggle when they try to implement a new currency, for example by entering a currency union.

Advantages

  • A currency union helps its members strengthen their competitiveness in a global scale and eliminate the exchange rate risk.
  • Transactions among member states can be processed faster and their costs decrease since fees to banks are lower.
  • Prices are more transparent and so are easier to compare, which enables fair competition.
  • The probability of a monetary crisis is lower. The more countries there are in the currency union, the more they are resistant to crisis.

Disadvantages

  • The member states lose their sovereignty in monetary policy decisions. There is usually an institution (such as a central bank) that takes care of the monetary policy making in the whole currency union.
  • The risk of asymmetric "shocks" may occur. The criteria set by the currency union are never perfect, so a group of countries might be substantially worse off while the others are booming.
  • Implementing a new currency causes high financial costs. Businesses and also single persons have to adapt to the new currency in their country, which includes costs for the businesses to prepare their management, employees, and they also need to inform their clients and process plenty of new data.
  • Unlimited capital movement may cause moving most resources to the more productive regions at the expense of the less productive regions. The more productive regions tend to attract more capital in goods and services, which might avoid the less productive regions.[2][3]

Convergence and divergence

Convergence in terms of macroeconomics means that countries have a similar economic behaviour (similar inflation rates and economic growth). It is easier to form a currency union for countries with more convergence as these countries have the same or at least very similar goals. The European Monetary Union (EMU) is a contemporary model for forming currency unions. Membership in the EMU requires that countries follow a strictly defined set of criteria (the member states are required to have specific rate of inflation, government deficit, government debt, long-term interest rates and exchange rate). Many other unions have adopted the view that convergence is necessary, so they now follow similar rules to aim the same direction.

Divergence is the exact opposite of convergence. Countries with different goals are very difficult to integrate in a single currency union. Their economic behaviour is completely different, which may lead to disagreements. Divergence is therefore not optimal for forming a currency union.[4]

History

The first currency unions were established in the 19th century. The German Zollverein came into existence in 1834, and by 1866, it included most of the German states. The fragmented states of the German Confederation agreed on common policies to increase trade and political unity.

The Latin Monetary Union, comprising France, Belgium, Italy, Switzerland and Greece, existed between 1865 and 1927, with coinage made of gold and silver. Coins of each country were legal tender and freely interchangeable across the area. The union's success made other states join informally.

The Scandinavian Monetary Union, comprising Sweden, Denmark and Norway, existed between 1873 and 1905, and used a currency based on gold. The system was dissolved by Sweden in 1924.[5]

List of currency unions

Existing

Currency Union Users Est. Status Population GDP (nominal $)
CFA franc Issued by the (French) Overseas Issuing Institute between 1945−1962 then by the Central Bank of West African States and the Bank of Central African States  Benin
 Burkina Faso
 Côte d'Ivoire
 Guinea-Bissau
 Mali
 Niger
 Senegal
 Togo
 Cameroon
 Central African Republic
 Chad
 Republic of the Congo
 Equatorial Guinea
 Gabon
1945 Formal, common policy 151,978,440
CFP franc Issued by the (French) Overseas Issuing Institute optimal currency area addresses the question of how to determine what geographical regions should share a currency in order to maximize economic efficiency.