International Policies: 3-Currency Monetary Union

Subject: Economics
Pages: 10
Words: 2796
Reading time:
10 min
Study level: PhD

Executive Summary

Recent economic crises have highlighted the failures of current economic policies in expanding and improving the efficiency of international trade. This paper investigates the failures of international monetary policies and their effects on global commerce. It also explores the effects of introducing a currency basket as an alternative currency model (as opposed to the current monetary system that uses the U.S. dollar as the main international currency) and explores the ramifications of introducing the gold standard to the proposed currency basket system.

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Introduction

Recent global economic crises have drawn a lot of attention to the inefficiencies of the global financial system. Particularly, researchers have expressed their concern about the future of the international monetary system as a subset of global business dynamics (Pugel, 2012; Mele & Baistrocchi, 2012). Underlying these concerns are currency movements in the world economy that have changed the dynamics of global trade. They have challenged contemporary beliefs about current international trade practices and exposed the weaknesses of contemporary business dogma that underlie global commerce. For example, some researchers have criticized the dominant United States (U.S.) dollar (as the world’s reserve currency) for its inability to create financial stability in the global marketplace (Pugel, 2012). Meanwhile, the U.S. dollar continues to play a crucial role in the world economy. For example, it accounts for 62% of the world’s foreign exchange reserves and 77% of all international loans (Henning, 2008). It is also the main currency for 40% of all international bonds and 44% of international deposits (Henning, 2008).

The growing strength of new currencies (from emerging economies) in the global marketplace has challenged dominant traditional currencies in many parts of the world. For instance, the Chinese Yuan has replaced the Japanese Yen as Asia’s most powerful currency (Cui, 2014). Not far behind is the Indian Rupee, which has also challenged the dominant Japanese Yen in Asia. The Euro has also had the same effect in Europe because it has challenged the U.S. dollar as the main exchange currency (Hovanov, Kolari, & Sokolov, 2004). Although the U.S. dollar remains the world’s reserve currency, pundits suggest that the future of the global economic system may exist in having a currency basket (Eiji & Junko, 2006). This paper explores this possibility and, based on the characteristics of the global economic system, strives to predict the future of the international monetary system by evaluating the prospects of introducing a three currency monetary union. Similarly, it explores the implications of adding the gold standard to the proposed economic model and finds out its effects on global trade. It also evaluates these proposals in lieu of the activities and goals of the World Trade Organization (W.T.O.) and the International Monetary Fund (I.M.F.) because these institutions are instrumental in promoting and expanding global trade (Narassiguin, 2013).

Fixed Exchange Rate Regime

A fixed exchange rate regime occurs when an economy pegs its domestic currency to another currency, at a fixed rate (Goldstein & Kestenbaum, 2011). Albeit unpopular, the fixed exchange rate regime has significant advantages and disadvantages. Countries that use the fixed exchange rate system prefer to use it because it minimizes currency fluctuations and stabilizes their economies (Goldstein & Kestenbaum, 2011). For example, some Japanese companies have shied away from investing in the United Kingdom (U.K.) because the European country is reluctant to use the Euro and convey the benefits of stable currencies to potential investors (Goldstein & Kestenbaum, 2011). Proponents of the fixed exchange rate currency also say it minimizes inflation by preventing the devaluation of currencies (Roberts, 1995). Comparatively, critics of the fixed exchange rate system say, fixed exchange rates conflict with other economic objectives, such as trade liberalization (Roberts, 1995). They also argue that this system is rigid, promotes current account imbalances and makes it difficult to know the right fixed exchange rates (Goldstein & Kestenbaum, 2011). The table below summarizes the advantages and disadvantages of the fixed exchange rate model.

Fixed Exchange Rate Regime
Advantages Disadvantages
Prevents currency fluctuations
Stable
Keeps inflation low
Conflict with other objectives
Rigid
Difficulty in knowing the correct fixed rate
Current Account Imbalances

Many countries use a flexible exchange rate regime because of the disadvantages associated with the fixed exchange rate system. For example, many countries prefer to use it because it accommodates fiscal and monetary policy interventions (Roberts, 1995). This way, the flexible exchange rate system acts as an automatic stabilizer of the economy. Critics of this system say it allows for exchange rate fluctuations and “excess” monetary intervention (Roberts, 1995). Furthermore, they argue that the some of the stabilizing effects of this model are questionable (Goldstein & Kestenbaum, 2011).

Prospects of Introducing a three Currency Monetary Union

A three currency monetary union would undermine the role of the U.S. dollar in global commerce. A monetary union occurs when “countries use a group of securities and their weighted average to find the value of an obligation, or the value of another country” (Hovanov et al., 2004, p. 4). Observers say adopting a currency basket model could benefit many economies by preventing them from exchange rate fluctuations (Pugel, 2012). For example, Eiji and Junko (2006) say the 1997 economic crisis in East Asia highlighted the weakness of the single-currency monetary system. To avoid such problems, Cui (2014) proposed that most countries should use a currency basket model. Some developing countries have failed to realize the benefits of minimal exchange rate fluctuations (through the basket currency system) because most of them are small economies that split their import and export currency variations into exchange rate changes of domestic currencies, as opposed to the import currencies (Cui, 2014). Similarly, their export currencies separate according to their weights in the currency basket. The currency basket model aligns with the principles of the purchasing power parity theory, which suggests that exchange rate adjustments should equalize the price of goods between two trading countries (Pugel, 2012). Critics of the basket currency model say it lacks transparency and is difficult to verify (Mele & Baistrocchi, 2012). They also believe that including multiple currencies in one model complicates the international monetary system, thereby making it difficult to manage (Mele & Baistrocchi, 2012). As a counter argument, proponents of the basket currency model say, the benefits of the system still outweigh its limitations (Mele & Baistrocchi, 2012). For example, Chincarini (2007) says East Asian countries would benefit from pegging their local currencies to a currency basket, as opposed to pegging their currencies to the U.S. dollar only. This model would benefit them because they already enjoy strong economic relationships with countries that reserve the dominant currencies (Japan, America, and European countries – E.U.). In this regard, Chincarini (2007) believes that the currency basket model should include three major global currencies – U.S. dollar, Euro, and the Japanese Yen. The table below summarizes the advantages and disadvantages of the currency basket model

Currency Basket Model
Advantages Disadvantages
Minimizes exchange rate volatilities, thereby creating stability
Allows developing countries to compete with developed countries
Taps into the growth of a currency trajectory
Lacks transparency
Is difficult to verify
Difficult to manage

The Effects of the Three-Currency Monetary Union on the Global Economy

G-20 countries

Having a three currency monetary union should create both policy and institutional management problems to G-20 countries. These issues would typically affect international monetary practices and the exchange rate management policies of these countries. Economically, having a three-currency monetary union would benefit members of the G-20 group by allowing them to extend their monetary stability to other countries (Henning, 2008). A three-currency monetary union would also positively influence these countries by reducing the transaction costs of trade and helping them to merge the global market under one basket currency model. Therefore, this model would benefit G-20 countries.

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Countries that do not belong to the G-20 Union

Countries that experience many types of economic shocks are likely to benefit from the adoption of different exchange rate regimes. For example, countries that are vulnerable to monetary shocks are likely to benefit from adopting a flexible exchange rate regime (Pugel, 2012). Similarly, countries that are vulnerable to real shocks could benefit from adopting a fixed exchange rate regime. For example, energy market shocks could significantly affect oil-producing countries. Therefore, they are likely to benefit from a fixed exchange rate regime (Pugel, 2012). Many countries that do not belong to the G-20 union suffer from monetary shocks and not real shocks (Henning, 2008). Therefore, they are bound to benefit from adopting a flexible exchange rate regime. This is why they would benefit from the currency basket model. In this regard, such a model would protect them from exchange rate instabilities and allow them to compete favorably in the global marketplace.

Gold Standard

The gold standard is a financial system that allows countries to peg their currencies on a specific quantity of gold. Many western economies used this financial system in the late 1800s and early 1900s, until they abolished it after the great depression (Roberts, 1995). Recently, the prospect of returning to the gold standard to the global monetary system has preoccupied economic debates in Europe and in the U.S. (Pugel, 2012; Roberts, 1995). However, this paper argues that the gold standard is not feasible today because most of the factors that led to its abolishment prevail today. For example, in the 1930s, Britain abolished the gold standard because of inadequate gold reserves (Roberts, 1995). The same problem persists today. Furthermore, the current international monetary system is more effective than the gold standard because it allows governments to use monetary and fiscal tools to manage economies. It was difficult to do so using the gold standard. This is why some experts consider the abolishment of the gold standard (for the current monetary system) as the remedy that helped America overcome the Great Depression of the 1930s (Goldstein & Kestenbaum, 2011). Therefore, the gold standard is not feasible in the modern global economy.

The Effects of Including the Gold Standard in the Proposed Monetary System

Adding the gold standard to the currency basket model could negate its benefits because the proposed model seeks to create stability in the international monetary system, while the gold standard makes economies vulnerable to government manipulation (by varying gold reserves). Such vulnerabilities would complicate international trade and possibly limit its efficiency. Comprehensively, inadequate supplies of gold in the global market would make it difficult for nations to adopt the gold standard as a pivotal instrument of international trade.

The Effects of the Gold Standard on the Global Economic System

Economists who believe that the gold standard would have negative consequences on the global financial system argue that some governments could “hoard” gold and easily manipulate the financial system (Roberts, 1995). Therefore, they support the current monetary framework because it is a “fluid system” that allows for the easy flow of capital. Furthermore, they say this framework allows for easier storage and transportation of money, unlike gold, which requires huge storage spaces and heavy machinery to move (Roberts, 1995). In an unrelated context, relatively small quantities of gold in the world, compared to the demand of the commodity that would arise if all countries adopted the gold standard, worries some economists because they believe an acute shortage of the commodity would undermine its reintroduction in the global financial system (Roberts, 1995). Based on these concerns, pundits believe that its reintroduction would complicate the international monetary system, thereby making the global economy vulnerable to economic crises (Roberts, 1995). However, people who support the gold standard believe that its durability, the rarity, and divisibility of gold would benefit the global economic system (Roberts, 1995; Mele & Baistrocchi, 2012). Furthermore, they argue that its ease of identification would help the global financial system to avoid some of the challenges that undermine the current financial system. Based on these views, some researchers believe the gold standard would protect the global financial system from some of the manipulative tendencies that characterize the global financial system (Roberts, 1995). Countries reported such benefits during the great depression because it protected them from imminent financial collapse (Goldstein & Kestenbaum, 2011).

The Effects of the Gold Standard on I.M.F. Goals

The goals of the international monetary fund (I.M.F.) are diverse. They include promoting international partnerships, expanding global trade, and promoting a stable global economic system (Narassiguin, 2013). Auxiliary goals include eliminating trade barriers, providing members with helpful measures to correct their balance of payments, and minimizing inequities in the global financial system (Narassiguin, 2013). Based on these goals, reintroducing the gold standard would have to complement I.M.F. goals if countries should accept the strategy in the global financial system (Narassiguin, 2013). However, based on the unequal distribution of gold throughout the world, some countries (mainly gold-producing countries) would have an unfair advantage over non-producers and create new impediments to trade. Such an outcome would impede the goals of the I.M.F.

The Effects of the Gold Standard on the W.T.O. and G.A.T.T. Goals

The World Trade Organization promotes General Agreement on Trade and Tariffs (G.A.T.T.) goals, which strive to support international trade. These goals also aim to standardize and regulate international trade. To meet these goals, the W.T.O. strives to lower international trade barriers (such as taxes and tariffs). The basket currency model would complement the goals of the W.T.O. and support G.A.T.T. goals because the model strives to streamline international trade by reducing the inefficiencies caused by currency fluctuations (Pugel, 2012). Having a global reserve currency would expand international trade by minimizing the inefficiencies created by using credit-based national currencies. Furthermore, since a basket currency model includes different currencies, it would encourage partnerships in international trade, thereby complementing the goals of the W.T.O.

Discussion

Many economic analysts have explored the controversy surrounding the fixed and flexible currency model in the global marketplace (Pugel, 2012). Critics of the currency basket model say that although it may have many advantages, most of the countries that have adopted it, so far, still have their currencies pegged to the U.S. dollar (Eiji & Junko, 2006). For example, they demonstrated that currency movements in some major Asian currencies, before 1997, reflected similar movements in the value of the U.S. dollar during the same period (Eiji & Junko, 2006). However, they believe that the benefits of using the currency basket model greatly outweigh its disadvantages, relative to the exchange rate fluctuations that ordinarily limit the efficiency of international trade. Therefore, the greatest benefit of the currency basket model is the opportunity it provides economies to limit the uncertainties associated with exchange rate fluctuations (Pugel, 2012). They occur from overvaluing or devaluing national currencies. For example, if countries overvalued their currencies, they would limit the volume of exports that could come from selling their goods internationally. Similarly, if they undervalued their currencies, they would experience economic overheating and imported inflation. Therefore, adopting the basket currency model would greatly benefit countries that have a positive balance of payments.

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Conclusion

Recent economic crises have highlighted the failures of current economic policies in expanding international trade and making it efficient. This paper has investigated the failures of international monetary policies and their effects on international trade. It has also explored the effects of introducing a currency basket as an alternative currency model (as opposed to the current monetary system that uses the U.S. dollar as the main international currency). In the same fashion, this paper has explored the ramifications of introducing the gold standard to the proposed currency basket system and highlighted its effects on international trade. Lastly, considering W.T.O. and I.M.F. are instrumental organizations for promoting international trade, this paper has also explored the effects of these proposed policy changes on these institutions. Based on these areas of study, this paper demonstrates that introducing a currency basket model to the international trade framework would benefit both G-20 countries and those that are not part of the union. Indeed, using multiple currencies would introduce stability and predictability in their international trade engagements. This is why proponents (of this system) say this basket currency model would introduce flexibility and stability in the global financial system, thereby making it easy for developing countries to compete favorably with developed countries. In this regard, this study shows that a currency basket system could promote the activities of the I.M.F. and the W.T.O. because both institutions strive to lower the barriers to international trade. Therefore, since currency fluctuations inhibit international trade, the basket currency model would support the activities of these global institutions. Therefore, a quasi-fixed system would positively work in the global marketplace by creating an optimum currency area (a geographical precinct, which would benefit from economic efficiency by adopting a single currency). The success of the E.U. exemplifies the need for having the optimum currency area because the dominance of the Euro in global trade has stabilized the European region (economically) and improved trade in the same respect.

References

Chincarini, L. (2007). The Effectiveness of Global Currency Hedging after the Asian Crisis. Journal of Asset Management, 8(1), 34-51.

Cui, Y. (2014). Revisiting China’s Exchange Rate Regime and RMB Basket: A Recent Empirical Study. International Journal of Economics and Finance, 6(2), 150-160.

Eiji, O., & Junko, S. (2006). Progress towards a Common Currency Basket in East Asia. Web.

Goldstein, J., & Kestenbaum, D. (2011). Why We Left The Gold Standard. Web.

Henning, R. (2008). Europe’s Monetary Union, the United States and International Cooperation. Web.

Hovanov, N., Kolari, J., & Sokolov, M. (2004). Computing Currency Invariant Indices with an Application to Minimum Variance Currency Baskets. Journal of Economic Dynamics and Control, 28(1), 1481-1504.

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Mele, M., & Baistrocchi, P. (2012). Still on China’s Exchange Regime: The Euro and its Role as an Anchor Currency. Asian Journal of Finance and Accounting, 4(1), 205-215.

Narassiguin, P. (2013). The Goals Of The International Monetary Fund (IMF). Web.

Pugel, T. A. (2012). International Economics. Boston, MA: McGraw-Hill.

Roberts, M. (1995). Keynes, the Liquidity Trap and the Gold Standard: A Possible Application of the Rational Expectations Hypothesis. The Manchester School of Economic & Social Studies, 61(1), 82–92.