Essential definitions

Monetary union

Economies sharing a currency and common monetary arrangements.

Asymmetric shock

A disturbance affecting member economies differently.

Monetary policy

Central-bank decisions about interest rates and monetary conditions.

What a shared currency changes

A monetary union shares monetary arrangements, including a common currency in the model considered here. Members avoid exchanging currencies for transactions with each other and can compare prices more easily. Removing internal exchange-rate risk can encourage cross-border contracts and investment. A credible common central bank may also support stable inflation expectations.

Members give up their own policy interest rate and cannot depreciate against one another. This matters when shocks differ. If A faces recession while B has strong demand and inflation, a common interest-rate increase may restrain B but weaken A further. One instrument cannot precisely match both economies' needs.

Explain alternative adjustment mechanisms

Workers may move from a member with unemployment to one with vacancies. Fiscal transfers may support spending in the weaker region. Flexible wages and prices or productivity gains can improve its competitiveness without a national currency depreciation. Similar economic cycles reduce how often conflicting needs arise.

Each adjustment has limits: language, qualifications and housing impede mobility, wage cuts can be painful, and transfers require finance and political support. Without effective alternatives, output and employment losses may persist. Compare the gains from monetary stability with the cost of losing national responses, using the members' actual links and shocks. Greater trade alone does not prove that the common policy will suit everyone.

Apply and evaluate

• Currency stability and lower transaction costs must be weighed against the loss of national monetary responses.