What is a Merged Currency?

An approach to exchange rate policy is for a nation to choose a common currency shared with one or more nations is also called a merged currency. 

A merged currency approach eliminates foreign exchange risk altogether. Just as no one worries about exchange rate movements when buying and selling between New York and California, Europeans know that the value of the euro will be the same in Germany and France and other European nations that have adopted the euro.

However, a merged currency also poses problems. Like a hard peg, a merged currency means that a nation has given up altogether on domestic monetary policy, and instead has put its interest rate policies in other hands. When Ecuador uses the U.S. dollar as its currency, it has no voice in whether the Federal Reserve raises or lowers interest rates. The European Central Bank that determines monetary policy for the euro has representatives from all the euro nations. However, from the standpoint of, say, Portugal, there will be times when the decisions of the European Central Bank about monetary policy do not match the decisions that a Portuguese central bank would have made.

The lines between these four different exchange rate policies can blend into each other. For example, a soft peg exchange rate policy in which the government almost never acts to intervene in the exchange rate market will look a great deal like a floating exchange rate. Conversely, a soft peg policy in which the government intervenes often to keep the exchange rate near a specific level will look a lot like a hard peg. A decision to merge currencies with another country is, in effect, a decision to have a permanently fixed exchange rate with those countries, which is like a very hard exchange rate peg. 

Global macroeconomics would be easier if the whole world had one currency and one central bank. The exchange rates between different currencies complicate the picture. If financial markets solely set exchange rates, they fluctuate substantially as short-term portfolio investors try to anticipate tomorrow’s news. If the government attempts to intervene in exchange rate markets through soft pegs or hard pegs, it gives up at least some of the power to use monetary policy to focus on domestic inflations and recessions, and it risks causing even greater fluctuations in foreign exchange markets.

There is no consensus among economists about which exchange rate policies are best: floating, soft peg, hard peg, or merged currencies. The choice depends both on how well a nation’s central bank can implement a specific exchange rate policy and on how well a nation’s firms and banks can adapt to different exchange rate policies. A national economy that does a fairly good job at achieving the four main economic goals of growth, low inflation, low unemployment, and a sustainable balance of trade will probably do just fine most of the time with any exchange rate policy. Conversely, no exchange rate policy is likely to save an economy that consistently fails at achieving these goals. Alternatively, a merged currency applied across wide geographic and cultural areas carries with it its own set of problems, such as the ability for countries to conduct their own independent monetary policies.

Related Topics

• What Does it Mean to Dollarize
• Foreign Exchange Market
• Who Demands and Supplies Currency in a Foreign Exchange Market? 
• Foreign Direct Investment
• Greenfield Investment
• Brownfield Investment
• Portfolio Investment
• Hedging
• Dealers in the Interbank Market
• Weak and Strong Currency
• Depreciation of Currency 
• Appreciating and Depreciating Currency
• Exchange Rate
• Real Effective Exchange Rate (REER)
• Limited Flexibility Exchange Rate System
• Expectations about Future Exchange Rates Shift Demand
• Expected rate of return shift demand and supply for a currency
• Relative Inflation Shifts Demand and Supply for a Currency
• Purchasing Power Parity (PPP)
• Relative Purchasing Power Parity
• Law of One Price
• Burgernomics
• Balassa-Samuelson Effect
• Arbitrage
• Tobin Tax
• Foreign Exchange Market
• Foreign Exchange Contract
• Arbitrage
• Hedge
• Why Central Banks Care About Exchange Rates
• How Do Exchange Rates Affect Aggregate Demand and Aggregate Supply? 
• What Causes Exchange Rate Fluctuations?
• Exchange Rate Policy
• Fixed Exchange Rate 
• Floating Exchange Rate
• Hard and Soft Peg
• What is a Merged Currency?
• Capital Control
• Exchange Stabilization Fund