The benefits of forming a currency union derive from reductions in transactions costs and uncertainty, and a monetary union's success is measured in the extensive literature on `optimal currency areas' by its ability to withstand economic shocks. In Discussion Paper No. 617, Paul Masson and Research Fellow Mark Taylor review this literature and more recent analyses that focus on the nature of such shocks. Both suggest that the benefits of a currency union increase with intra-union trade, labour mobility and nominal wage and price flexibility, if the constituent national economies have diversified industrial structures, and if shocks are predominantly union-wide rather than country-specific.

Masson and Taylor focus on the EMS member countries, where the high level of internal trade, the diversification of most national economies and the fairly symmetric character of shocks are all advantageous, but labour mobility is lower than in North America. Forming a currency union also entails changes in economic structure and has major political implications for the design of Europe's new monetary institutions. In particular, fiscal policy coordination through rules or institutional procedures may safeguard against the unfavourable spillover effects of excessive public deficits, but more flexible, `discretionary' coordination may be more suitable where such effects arise from stabilization policies. Setting up the institutions of fiscal federalism of the North American type is primarily a political decision, which balances loss of national sovereignty against the pursuit of common goals. Neither economic theory nor North American experience identifies a unique level of nominal or real convergence that is necessary or sufficient for a monetary union to succeed. Real convergence has taken place in the US (albeit slowly), but the European Community's current divergence of real per capita output is some ten times greater, and the new authorities' anti- inflation reputation will also significantly affect the costs of disinflation.

Masson and Taylor finally consider the transition to monetary union in the context of Europe's wider economic and political integration. Some argue that forming a monetary union requires prior convergence of inflation rates: otherwise political tensions among its constituent parts may compromise the common monetary authority's independence. If free movement of goods and services and the abolition of exchange risk reduce factor price and per capita output differentials, however, and there is no long-run trade-off between inflation and unemployment, all union members will have an interest in price stability. Establishing a supranational monetary authority will promote inflation convergence, so it should not be set as a precondition.

Common Currency Areas and Currency Unions: An Analysis of the Issues
Paul R Masson and Mark P Taylor

Discussion Paper No. 617, February 1992 (IM)