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Part - II

• Increased credibility of monetary policy. If an inflation prone country adopts the currency of a credible anchor, it eliminates the inflation bias problem*. This bias could be due to over stimulation of economy in an upward part of the cycle or due to monetization of budget deficits.

Sharing a common currency is a much more serious and durable commitment than a fixed exchange rate. As the history shows, fixed rates are not irrevocably fixed and hence they lack full credibility. To the extent that a currency union is more costly to break than a promise to maintain a fixed exchange rate, the currency adoption is more credible. The countries that stand to gain the most from giving up their currencies are those that have a history of high and volatile inflation. This kind of history is a symptom of a lack of internal discipline for monetary policy. Hence, to the extent that this lack of discipline tends to persist, such countries would benefit the most from the introduction of external discipline.

The biggest cost of forming and being a part of a monetary union is the loss of monetary independence. The member nations would no longer be able to conduct their own monetary policies. Instead, a common central bank, with participation of all member countries, sets a single monetary policy for the entire union. The central banks of the individual countries will play a role similar to that of a regional Federal Reserve Banks in the U.S.: they will monitor local conditions but they will have no control over the money supply or the interest rates. Cost of losing national monetary policy can be too large. If a recession hits one country but not others in the monetary union, that country may indeed wish it had the tool of monetary policy to combat the downturn. If the regulator selects a policy that takes into account the shocks experienced by member countries, currency unions would look more attractive. Thus greater the association of such shocks between the member nations, the better and easier it is to form a currency union.

The Asian currency crisis has been an eye-opener for many Southeast Asian economies and has acted as a driver to the move towards a common currency. The S.E.Asian economies in particular have realized the undesirability of pegging currencies to the dollar. It has led to excessive capital flows and loss of competitiveness. The currency-maturity mismatch arising out of borrowing in non-local currency and lending in local currencies has had severe consequences. A trend of American dollarization and expansion of euroland has made Asia "left out .Its time to strike back!

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* http://www.nber.org/papers/w9072

* Contributed by -
Harshdeep Jolly, Anshul Mittal & Pankaj Jain,
PGP 2,
IIM Bangalore.