Chapter 4: Does NAFTA Move North America Towards a Common Currency Area?
William C. Gruben and Jahyeong Koo Introduction Following the inception of the North American Free Trade Agreement on 1 January 1994, the idea of a common currency area that includes the three nations of NAFTA has received much public attention. This should not be surprising. When someone borrows from abroad, devaluation risk may be factored into the borrowing cost when the lenders’ country and the borrowers’ country do not use the same currency – sometimes even if the loan is denominated in the lender’s currency. The United States is a significant source of credit for Mexican firms and for Mexico’s central government. Moreover, Powell and Sturzenegger (2003) find evidence that in Latin America, greater currency risk causes greater country or debt risk. Second, countries that give up their currency are surrendering a measure of monetary policy independence. One benefit is that when countries with problematic inflation histories commence sharing a currency with a country with a good inflation history, the former countries no longer have central banks that created those bad histories. To the extent that the national central bank with a good record in inflation control influences the new currency arrangements of the problem history countries, market anticipations of inflation will ebb. The new expectations affect credit costs, credit availability and, in particular, the availability of longer term credit.1 Third, sharing a currency lowers the transaction costs of international commerce in goods and services between the sharing countries. When countries trade a great deal with each other, sharing a currency...
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