Changes to the inflation rate in countries that join a Monetary Union that uses a common currency

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1.1 Changes to the inflation rate in countries that join a Monetary Union that uses a common currency

A Monetary Union refers to a situation in which there is the presence of a single monetary policy among the member economies which is established by an intergovernmental legal agreement (International Monetary Fund 2009). One spcial monetary union is a currency union n which the original difference currencies of the member states are replaced by a common currency (Visser 2004, p.180).

Inflation rate is the percentage rise in the price level calculated over a period of time (Maier & Nelson 2007, p.157), usually based on one month or one year. Inflation rate is an important indicator in an economy not only because it measures the trend of the changes of the major products in the society that has closed relationship with the welfare of the common people but also because inflation is not necessarily a bad thing and it is believed that moderate inflation rate could help with the economy development and also there are other economic implications. Below we will the changes brought to the economies that join a Monetary Union and use a common currency. In following there are several major changes that we will focus:

1.1.1 Union inflation rate located between the high and low inflation rates

As proposed by Paul de Grauwe (2007, p.146), there will be a so call inflationary bias when the monetary union as set up. As shown in the figure below, he assumes that two countries, Italy and Germany, come together to form up a monetary union. In his assumptions, the German government strives for low inflation rate while Italian government’s preference for low inflation rate is less than that of the German government. And inflation rate in Italy is higher than that of Germany before the forming of the union and the two countries share the same unemployment rate. As analyzed in the model below, due to the monetary union has to take into consideration of the preference of difference levels of inflation rate of the two countries, the common inflation rate may probably be located between the high end E1 and the lower end Eg though it will lead to welfare losses in Germany, the country with a lower level of inflation rate.
Figure 1 The inflation bias in a monetary
Source: Grauwe 2007, p.146

1.1.2 A single inflation rate

To set up a common currency among two or more countries that use different currencies, it would requires all the member countries to gradually fix the exchange rates among the members and then replace the currencies with a single currency and then a single common currency will be introduced to the monetary union. When these conditions are met, the rate of the inflation among the member countries will converge to only one rate (Nelson & Neack 2002, p.461).

1.1.3 Harmonization of the inflation rates

As it is widely accepted that large degree of divergence between a country and the union average inflation rate could probably lead to unsuccessful new membership or for all the members when the common currency is to be established, this would requires a harmonization of the inflation rates for the new members states which would help achieve the price and fiscal stability. Take the GCC as an example, in year 2007, with a target to establish a common currency, an agreement was made which requested that the members states had to control their inflation rates (calculated based on GDP value) within two percentage of the average inflation rate among the members (MacDonald & Faris 2010, p.13). Similar case could also be found when a new country wants to join the European Union, harmonization of the inflation rate would be a condition to be achieved by the new candidates or members in order to set up such a monetary union.

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