Currency Substitution and Western European Monetary Unification

The recent history of European monetary affairs may be interpreted as slow movement towards the establishment of European currency union characterized by fixed exchange rates and perhaps, eventually, common European currency. Until very recently, the desirability of European monetary union was analysed in terms of the traditional optimum currency area framework.' In that analysis, the incentive for currency union comes from the potential improvements in efficiency in resource allocation from the use of single money in trade area. Recently, however, the question of the independence of monetary policy under flexible exchange rates has spawned growing literature on currency substitution which includes implications for currency 2 union. The earlier work suggested that major benefit of flexible rates would be the liberation of domestic monetary policy from external balance concerns, so that policy could be aimed singularly at internal balance.3 The currency substitution (CS) literature has demonstrated that, if the currencies of two countries are close substitutes to money-demanders, then the central banks of these countries cannot follow independent monetary policies even under flexible exchange rates.4 The degree of currency substitution is an important empirical question, and the analysis that follows should prove informative in determining the incentive for European monetary union. Is the European Monetary System (EMS) goal of reducing exchange rate fluctuations necessarily indicative of European sensitivity to disturbances with a substantial part of the problem coming from substitution between monies (Girton and Roper, 1980, p. 157), or rather result of the traditional drive towards integration as envisioned by optimum currency area theory? The following sections will suggest an answer

Currency · Currency substitution · Devaluation · Economics · European union · Exchange rate · Foreign-exchange reserves · International economics · Monetary base · Monetary economics · Monetary hegemony · Monetary policy · Reserve currency · European Monetary and Fiscal Policies · Global Financial Crisis and Policies · Monetary Policy and Economic Impact

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