A monetary union is a zone where a single monetary policy prevails and inside which a single currency, or currencies which are perfect substitutes, circulate freely. Most countries issue their own currencies that are not linked to others and thus constitute monetary unions on their own. However, this chapter examines only the cases of monetary unions that extend across national borders to a group of sovereign countries. Lessons are drawn from their experience in the next chapter.
Polly Reynolds Allen (1976, p. 4) distinguishes between those elements that define a monetary union and those additional characteristics that are necessary for the continued and successful existence of the monetary union. A monetary union is defined by the following characteristics: (1) a single money, or several currencies fully convertible at immutably fixed exchange rates; (2) an arrangement whereby monetary policy is determined at the union level, allowing no national autonomy in monetary policy; and (3) a single external exchange rate policy (“Toward this end, national authorities must relinquish individual control over their international reserves and invest such control in a union authority,” Allen, 1976, p. 4).
A related concept is “monetary integration.” A monetary union is an example of full (or nearly full) monetary integration. Monetary integration has been defined by Max Corden as involving two components;” exchange-rate union, that is, an area within which exchange rates bear a permanently fixed relationship to each other …” and “convertibility—the permanent absence of all exchange controls, whether for current or capital transactions, within the area” (Corden,1972, p. 2). He goes on to distinguish a true exchange rate union from a “pseudo-exchange rate union,” where there is an agreement to maintain fixed exchange rates but “there is no explicit integration of economic policy, no common pool of foreign-exchange reserves, and no single central bank” (Corden, 1972, p. 3). Since the tools for maintaining exchange rates permanently fixed do not exist in a pseudo-exchange rate union, there is always the possibility that one or another country would find it expedient to allow its rate to depreciate or appreciate against the others. The expectation that this may occur will interfere with the smooth operation of monetary union and prevent complete monetary integration. Similarly, Cobham and Robson (1994) distinguish between formal and informal monetary unions; the latter are not completely credible and hence, in their view, have drawbacks relative to formal monetary unions.
Thus, all the above authors stress the need for institutional safeguards to ensure that there will be a single monetary policy and, if there is more than a single currency, an irrevocable fixation of exchange rates. The need for such guarantees explains why the authors believe that the continued existence of national central banks and national currencies casts some doubt on the permanence of the union: they make exit from the union too easy. Similarly, pooling of reserves is viewed as essential to ensure a common external policy for the currency union.
More fundamentally, the permanence of a monetary union requires a strong bond of solidarity among member countries. Cohen (1998, p. 87) argues that in the absence of a dominant power with an interest in making the arrangement function effectively on terms acceptable to all, there must be a genuine sense of community among the partners. This sense of community may be the result of a long period of close cooperation and it may be manifested by other institutions that enable each member to benefit from assistance from the others if suffering unfavorable circumstances. Cohen points to cases where the absence of a hegemonic power or of solidarity among members led monetary unions to fail.
In order to get the widest possible benefits of a common currency as a means of payment, convertibility within the area is essential. Typically, enlarging a currency’s area of circulation is a key objective of monetary union, but this is only useful if the currency can fully serve as a means of payment; that is, the currency is internally convertible within the region. External convertibility also enhances the usefulness of the currency for residents of the monetary union, since restrictions on the ability to acquire foreign currency to make external transactions may provide incentives for domestic residents to hold foreign currencies (legally or illegally). External convertibility is not a defining feature of a monetary union, however.
The function of a currency as a store of value (and ultimately as a medium of exchange) depends on the currency keeping its value in terms of goods and services against which it is exchanged. This, in turn, requires an institutional setting in which the responsibility for the single monetary policy of the currency area is clearly established, the mandate is given to the central bank to maintain the value of the currency, and the central bank is granted the independence and tools for achieving that mandate. In particular, the common monetary policy must not allow for uncontrolled sources of monetary expansion nor should the central bank be subject to pressures to provide direct financing of government deficits or indirect financing through the banking system. The central bank must be able to alter the quantity of high powered money and the level of interest rates in order to control monetary expansion and achieve price stability.