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Currency Union And Consumption Fluctuation Analysis

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THEORETICAL EXPLANATION
Currency Union is defined as a situation where either several small countries(called clients) adopt the currency of a large country (anchor) or many countries create a new currency and a joint Central Bank. It affects price, trading pattern and economic policies.
There is a net welfare gain when the potential benefit from joining a currency union is greater than the loss. As stated earlier, the benefit is reflected from an increase in consumption and output due to trade creation, as well as by providing a credible monetary policy anchor. While the cost is attributed to consumption and output fluctuations from the loss of an independent monetary policy. The cost of joining a currency union through business cycle is captured …show more content…

A union results in fluctuation in consumption volatility of the client country. This increase in volatility due to a shock can sometimes have permanent effect on welfare. When there is a high volatility, those world would be preference for a risk-neutral technology and those might be a fall in investment in growth-oriented activities. Monetary policy plays a decisive role in any financial crisis. A tight monetary policy can reduce the depreciation of a currency and an expansion can alleviate output cost of a shock. Joining a currency union can lower the intensity of a financial crisis or any other disaster. Elimination of exchange rate fluctuations or adoption a credible peg with some macroeconomic policies combined with sufficient amount of international reserve can protect from such shocks.
Bilateral military conflicts are reduced since a union integrates country politically and hence they are interdependent.
A currency union which lowers the probability of a disaster(shock) can also nullify the effect of an independent monetary policy in tackling with the loss due to the disaster. Besides, a union might induce fiscal conflicts between countries if individual interests are not preserved which would ultimately trigger volatility due to a shock. Overall, the ability of a currency union to work depends on the extent to which an individual

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