Question

Can someone please help me with this??

Question 2) Some countries have chosen to join currency unions, such as European Union. This would imply sacrificing their own currencies in favor of using a common currency. a. What is the implication of this exchange rate policy for domestic monetary policy? Explain in detail. b. If a country ina currency union can set its interest rate independently, what can you say about the capital markets in this country? Explain in detail.

Answer 1

a) A currency union is the kind of arrangement where group countries agree to use a single currency. This lowers transaction cost and creates a single economic entity which could smoothen trade and also the movement of capital and labor.
The EU or European Union is one of the examples of such a currency union.
However, a currency union creates a single economic entity and it means the countries which are agreed to join the union will lose any freedom to have a separate monetary policy. The currency union must have a single central bank which governs the monetary policy. Any member country can not change the monetary policy because it could lead to instability of the currency.
If the domestic economy is in the recession then monetary policy can't be used as the said authority remains with the central bank of the union.

b) A member country can not set its interest rates independently if it is in the currency union. If such a thing happens then it will destabilize the currency of the whole union. A unilateral decrease in the interest rate by a member country will increase money supply and if that country is big enough then it will lead to unexpected depreciation in the currency. Similarly, any increase in interest rate will appreciate the currency and that will hurt the export of the other countries.
The capital market of such a country could be unstable because if it raises interest rate then it will see an inflow of capital and that will increase inflation as well as borrowing cost of the capital.