Free Trade Area vs Customs Union vs Monetary Union
Learn the difference between a free trade area, customs union and monetary union, including trade barriers, common tariffs and shared monetary policy.
A free trade area removes trade barriers between member countries, a customs union also sets a common external trade policy, and a monetary union goes further by sharing a currency or monetary policy.
Free Trade Area
A free trade area is a group of countries that removes or reduces tariffs and other trade barriers on goods traded between members. However, each member keeps control over its own trade policy with non-members.
For example, one member could impose a low tariff on imports from a non-member, while another member imposes a high tariff. This creates a potential problem called trade deflection, where imports enter through the member with the lowest external tariff and then move freely to other members.
Customs Union
A customs union has the features of a free trade area, but members also agree to a common external tariff. This means that the same tariff is usually charged on imports from countries outside the union.
A customs union therefore reduces trade barriers between members and prevents trade deflection. However, members lose some independence because they cannot normally set completely separate external trade policies.
Monetary Union
A monetary union is an agreement in which members share a common currency or coordinate their monetary policy. Monetary policy includes decisions about interest rates and the money supply.
A monetary union can reduce exchange-rate uncertainty and make trade and investment between members easier. However, members may lose the ability to set interest rates or use exchange-rate changes to respond to economic problems affecting only one country.
Key Difference
The main difference is the depth of integration:
- A free trade area removes internal trade barriers.
- A customs union removes internal trade barriers and uses a common external tariff.
- A monetary union involves sharing a currency or monetary policy, so it represents deeper economic integration.
Common exam mistake: do not confuse a customs union with a monetary union. A customs union concerns trade policy; a monetary union concerns currency and monetary policy.
