Transaction Costs

key terms

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currency

exchange rate

international trade

Smaller transaction costs in doing business across borders

Example 1:

Let’s say you want to buy a pair of pants. Before the monetary union, you would look and see that pants cost either 100 mark in Germany or 8505 pesetas in Spain. You look up the exchange rate to convert the currency, and find that the exchange rate between the mark and the peseta is 100 mark = 8507 pesetas. With 100 mark you could have bought a pair of pants in Germany, but if you had exchanged those 100 mark for pesetas you could buy the Spanish pants and still have 2 pesetas remaining, so the pants are slightly cheaper in Spain. Assume that you only have mark and no pesetas. You might want to buy the cheaper Spanish pants, but in order to buy them you have to go to your local currency converter, which costs you time and inconvenience (which is worth something to you).  Once you get to the currency exchanger, he/she might actually charge you a small fee for his/her work in exchanging your currency.  At this point is it not worth buying the Spanish pants because of the cost involved in getting the pesetas.

Now assume you have a common currency and pants are 100 € in Germany and 99 € in Spain. You no longer have to exchange any currency because you, Spain, and Germany are using euros. You can just as easily buy the cheaper Spanish pants. 

Example 2:

You can also think about it in terms of the seller. If the seller wants to take pants made in Spain and sell them in Germany, he/she must accept mark in Germany then exchange them into pesetas to conduct the business of pant making in Spain. There will be a transaction cost of exchanging his/her earned mark into pesetas. This makes selling in Germany just a little more expensive. If however, there are no currency transaction costs, the cost of selling in Germany becomes less expensive and more Spanish companies will sell in Germany, increasing trade (especially if their product is just a little cheaper – leading to greater competition and better prices for consumers). 

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