Monetary Arrangements in Free Trade Areas and Customs Unions

Free trade areas and currency areas reinforce one another. But uncertainty over exchange rates affects trade directly because it affects profit margin and small changes in exchange rate can completely wipe out expected profits. For this reason different countries are using the same currency in the trade area to minimize the risk. Free trade area has some problem, such as uncertainty over exchange rate, devaluation by a partner country etc. It is important for a currency area to be large. According to the journal there could be a basket of three currencies, such as dollar, yen and euro. But there is a problem with using a currency basket is that it is usually not a transparent target for monetary policy. Another problem of this currency basket is that it is not possible to get capital market integration. Besides that there is an advantage for multiple-currency basket is that it does not suffer from the possible defect of a single-currency basket. Now the question is about exchange rate. Under fixed exchange rate there is no problem of the adjusting process between two areas of a common currency area. But one thing is that the problems of slow-growing and poor countries are greater than fast-growing and rich countries because they lack the prospect of improving themselves as rapidly as fast-growing country.

Central Banks, Dollarization and the Maastricht Conditions

Central Banks are in most countries a comparatively recent event and most central Banks in the world were the creature of the twentieth century. The broken down of international gold standard also help to build up these central banks. Central banks were introduced to full-fill a deeply-felt need. Under the gold standard there was a periodic crises, which created a demand for elastic monetary system and central Banks became an instrument of that elasticity. Now let us consider Dollarization. Dollarization is an option open not only for Latin America but also for other countries with substantial trade and connections to the United States. The gains from Dollarization are substantial because it implies a better monetary policy in addition to gain of world class currency. Prices all over the world would be denominated in the same unit and be kept equal in different parts of the world.

There are three costs of Dollarization. Such as, (1) The loss of seignior age, (2) The loss of a national symbol and (3) The loss of sovereignty. But Dollarization will increase the trade and investment a lot. Here we see that complete Dollarization is not good because of inflationary rate. There might be 50% Dollarization and other 50% will be local currency convertible into US dollar. The costs and benefits of Dollarization are not independent of the number of countries that participate. Here we see that the gains are larger when more countries participate in the Dollarization. This is about central bank and Dollarization. Now the question comes to whether there is a need for Maastricht-type condition or not. There is no need of Maastricht-type condition in a better economy. In the better economy Government has less chance to make any mistakes. It can borrow and run a deficit but it can’t run an inflationary deficit. The Maastricht-type conditions are needed to strap down ministers of Finance. Some time they kept running deficit and forcing the central bank to buy Government bond when the market no longer wanted them.
 
Exchange Rate Volatility and Internal vs. External Stability

The dollar, euro and yen areas make up nearly sixty percent of the world economy because there is a high degree of price stability in each area. But the exchange rates of these currencies are very volatile. The change of these currencies creates the problem on those countries, which are doing business with both currency areas. And this volatility creates a big problem on third countries. The volatility between dollar and yen is terrible for countries that are doing business with Japanese and American markets and this volatility played a big role in the so-called Asian crisis. The crisis was so-called because it creates problem only on four countries like Thailand, Malaysia, Indonesia and Korea. Their currencies were pegged and not very efficient to the dollar. And as a result of appreciating dollar they lost their market in Japan because they had debt fixed in dollar. Volatility of the exchange rates aggravates instability of the financial markets, disrupts trade and the efficiency of capital flows. Now we are going to discuss about Internal and external stability. Internal stability refers to a stable price level and external stability refers to a stable exchange rate and equilibrium in the balance of payments. According to Keynes internal stability is more important than external stability but it is better to have both.
 
Towards a World Currency

Currency is a medium of exchange. Dollarizing the world economy is the quickest and most effective way to produce a world currency. But the arrival of the euro makes the question for the need and possibility of a world currency. Once a moment in 19th century, England rejected the effort of France and America to produce a world currency. Now the creation of euro diminishes the monopolistic position of the dollar and at the same time US power in the international business also has to be shared. It is possible for United States that they will produce a genuine international currency in the future. The international monetary fund could be turned into a world central bank and granted the authority to produce a world currency. Then each participating member in the union would fix its local currency to the world currency. The world currency itself would be backed by the currencies of the three largest central banks. In this case the world central bank would stand ready to buy and sell the world currency on demand so that it would not add to or subtract from the world money supply. There would not be currency crises in participating countries as long as they adhered to the rules for fixed exchange rates. A world currency would provide a universal unit of account for transmitting values. Finally we can say that a common world currency is the second most important currency in every country because it has the magnificent power to develop international business.