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Published: 16-12-2012, 13:34

Multiple currencies: Costs of Multiple Currencies

Multiple currencies

Multiple currencies: Benefits of Multiple Currencies

Multiple currencies: Need to Weigh the Costs and Benefits

Although multiple currencies have benefits, they also have a number of costs.An important cost is the loss of flexibility in the conduct of monetary policy. It is generally believed that central banks can help smooth the fluctuations affecting an economy with the judicious use of monetary policy. In a recession, an expansionary monetary policy can stimulate the economy; in an expansion, a tight monetary policy can prevent the economy from growing too fast.

Multiple currencies reduce the central bank’s ability to stimulate the economy with an expansionary policy that increases the rate of growth of the money supply. Moreover, monetary policy is less effective since it affects only a fraction of the economic activity.The central bank is unable to stabilize the local economy as well as it could if multiple currencies did not circulate. The consequence is volatility that hurts businesses and consumers.

Of course, the constraint imposed on monetary policy bymultiple currencies is partly by design. The benefits of multiple currencies arise because the monetary authority has a tendency to choose a monetary policy that is too loose. There is a trade-off between reducing the incentives of the monetary authority to choose high inflation and giving it flexibility to stimulate the economy. Multiple currencies can be socially desirable if the costs of high inflation are higher than the benefits of stabilization policy.This is likely to be the case when themonetary authority finds it especially difficult to implement low inflation.

The use of multiple currencies also reduces flexibility in other areas, such as the ability of the central bank to implement lender-of-last-resort policies. In cases of financial crises, the central bank can sometime enhance the stability of the financial system by temporarily providing a large amount of liquidity. The effectiveness of this kind of policy is likely to decline in the presence ofmultiple currencies. This is especially true if the financial systemrelies heavily on the foreign currency. For example, a lender-of-lastresort policy to prevent bank runs is less effective if a large fraction of deposits at banks are denominated in dollars. An additional cost of multiple currencies is the inconvenience experienced by businesses and consumers when they have to deal with several currencies, such as keeping track of inventories for each currency.

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