The effects of monetary integration : the case of Grenada in the East Caribbean monetary union

Abstract

Most developing countries create a central banking institution, either individually or jointly, as part of a monetary union. The islands in the East Caribbean were no exception. They opted for a joint institution, the East Caribbean Currency Authority, which was subsequently converted into a fully fledged central bank, the East Caribbean Central Bank (ECCB). This dissertation analyses the effects of the ECCB on the member economies of the ECMU. with special emphasis on the Grenadian economy. Because a monetary union involves the adoption of a single currency by a group of countries, a number of benefits and costs can be expected. The small volume of intra-union trade relative to the total trade of the member countries, the high and common degree of concentration of exports by product and destination. and the common concentration of impons in tenns of product and geographic origin, have meant that benefils to the ECMU countties from the elimination of the costs of money conversion for intra-union transactions, from the elimination of the costs of foreign exchange forward cover on transactions among members, and from the need to hold a smaller pool of foreign reserves, are extremely small. However, benefits arising from the reduced costs of having only one common central bank are substantial. It is sometimes feared that the jointly controlled monetary and exchange rate policies which may serve a majority interest, may not be suitable for particular countries and may create costs. Although the ECMU has restricted central bank credit to finance fiscal deficits, credit use in Dominica and Grenada in particular, was much higher than the limits imposed by the central bank agreement. It seems reasonable to postulate that in the absence of restrictions, higher fiscal deficits would have been financed by central bank credit. Given the likely adverse effects of fiscal deficits financed by central bank credit, the restrictive monetary policy seems to have been extremely beneficial to Grenada. Analysis of money supply changes indicated thai Ihe ECCB can not exen independent control over the money supply. Tn addition, the very openness of the economies and the high import content of domestic consumption mean that inflation is to a large extent imported, thus eliminating the usefulness of the exchange rate as a policy instrument for improving external payments imbalances. A macroeconometric model was constructed to study the effects of alternative policies on the Grenadian economy. Simulation of the model with monetary and exchange rate shocks suggests that Grenada's loss of autonomy in monetary and exchange rate policies does not seem to be costly. The only costs appear to have been the inability of the Grenadian authorities to revalue the currency to offset imported inflation. The benefits from monetary union thus seem unambiguously to outweigh the costs. Show more