Currency unions and trade: how large is the treatment effect?

The impact of a common currency on trade can be grossly mismeasured if countries that belong to currency unions are systematically different from those that do not, and if the relationship between trade and its observable determinants is complex. I argue that such complications are plausible and likely to distort the empirical results of a recent Economic Policy paper by Andrew Rose (Issue 30, 2000: pp. 7–45). Using techniques designed to be robust in this situation, I find that the effects of common currency on international trade are considerably less dramatic and much less precisely estimated.
I have always maintained that the measured effect of a single currency on trade appears implausibly large, but I am not convinced by Torsten Persson's diagnosis and proposed solution. I apply a variety of estimation techniques to a new larger data set, where many more instances of currency union creation and abandonment make it possible to rely on time–series as well as cross–sectional evidence. The results are similar to my earlier ones: the effect of a single currency on trade is large.     

Currency unions and trade: A post-EMU reassessment

In our European Economic Review (2002) paper, we used pre-1998 data on countries participating in and leaving currency unions to estimate the effect of currency unions on trade using (then-) conventional gravity models. In this paper, we use a variety of empirical gravity models to estimate the currency union effect on trade and exports, using recent data which includes the European Economic and Monetary Union (EMU). We have three findings. First, our assumption of symmetry between the effects of entering and leaving a currency union seems reasonable in the data. Second, our preferred methodology indicates that EMU has boosted exports by around 50%. While other estimation techniques yield different results, a panel approach with both time-varying country and dyadic fixed effects on a large span of data (across both countries and time) seems to deliver insensitive and reliable results. Third, different currency unions have different trade effects.     

One money, one market: the effect of common currencies on trade

A gravity model is used to assess the separate effects of exchange rate volatility and currency unions on international trade. The panel data, bilateral observations for five years during 1970–90 covering 186 countries, includes 300+ observations in which both countries use the same currency. I find a large positive effect of a currency union on international trade, and a small negative effect of exchange rate volatility, even after controlling for a host of features, including the endogenous nature of the exchange rate regime. These effects, statistically significant, imply that two countries sharing the same currency trade three times as much as they would with different currencies. Currency unions like the European EMU may thus lead to a large increase in international trade, with all that that entails.     

Does a currency union affect trade? The time-series evidence

Does leaving a currency union reduce international trade? We answer this question using a large annual panel data set covering 217 countries from 1948 through 1997. During this sample a large number of countries left currency unions; they experienced economically and statistically significant declines in bilateral trade, after accounting for other factors. Assuming symmetry, we estimate that a pair of countries that starts to use a common currency experiences a near doubling in bilateral trade.     

Supply-side effects of exchange rates, exchange rate expectations and induced currency depreciation

Within the context of a small open economy model, this paper examines the repercussions of induced currency depreciation. The results presented in this paper are based on a model with firm microeconomic foundations and which takes into account both the supply and demand-side effects of exchange rate variations. The distinguishing feature of the model is the role of exchange rate expectations. We consider three kinds of expectations; adaptive, extrapolative, and regressive expectations. We also perform several sensitivity tests based on these expectations. Our simulation exercise shows that the effect of induced currency depreciation depends largely on supply-side effects. In most cases, we find that currency depreciation results in (i) a fall in output, (ii) an increase in prices and (iii) an improvement in the balance of trade. In the absence of weak supply-side effects of exchange rates, we find that, if the Marshall-Lerner conditions hold, then depreciation of the home currency has a favorable effect on output but its effect on the balance of trade is negative.     

Trade implications of the Euro in EMU countries: a panel gravity analysis

In this paper, we study the intra-EMU and intra-Eurozone trade effects of the euro adoption on 29 European Economic and Monetary Union countries (including 17 Eurozone economies and Iceland) from the period 1994 through 2011. We employ a generalized gravity model that controls for an extended set of trade theory and policy variables. The gravity model is estimated using the robust panel data techniques that includes times effects, besides country-specific effects. The various econometric specifications of the gravity equation, on the whole dataset of 29 economies, yield positive and significant impact (to be around 14 %) of the euro currency adoption on bilateral trade flows. Next, euro effect on bilateral trade and exports on a smaller dataset is estimated. The estimated results suggest that bilateral trade and exports increase by 20.81 and 18.57 %, respectively, when both the countries belong to the Eurozone. This effect is larger than the one obtained when only one of the two trading partners uses the euro as its currency. In addition, the validity of the assumptions of Heckscher–Ohlin (H–O) theory are checked for the countries under study. The estimated results reject the H–O theory in favor of Modern Trade theories. However, the low value of the coefficient on respective variable suggests that, over the period, the type of trade among these countries has transited from inter-industry trade to horizontal intra-industry trade. This suggests that these developed European economies are on the path of economic convergence via intra-industry trade.     

Economic policy implications of the implementation of the single European currency

As it is well known, before the next century a single European currency, the Euro, will be introduced and European products will enjoy an extensive market. Economists have focused their attention on analyzing the different costs and benefits derived from the implementation of the single currency. With regard to the benefits of such an implementation, the most important ones are as follows. The introduction of a single currency will encourage internal demand and will help economic agents save transaction costs; labor distribution will improve; there will be less uncertainty in the markets; and, lastly, it will improve economic growth if technical transmission is facilitated. But there are also problems in the implementation of the single European currency. Credit institutions, especially banks and savings banks, will lose their income from the currency exchange process. It must also be considered that the economies will depend on the higher development level of the German economy. The goal of this paper is to analyze the costs and benefits derived from the implementation of a single currency.     

Ambiguity aversion and trade

What is the effect of ambiguity aversion on trade? Although in a Bewley??s model, ambiguity aversion always leads to less trade; in other models, this is not always true. However, we show that if the endowments are unambiguous, then more ambiguity aversion implies less trade for a very general class of preferences. The reduction in trade caused by ambiguity aversion can be as severe as to lead to no trade. In an economy with MEU decision makers, we show that if the aggregate endowment is unanimously unambiguous, then every Pareto optima allocation is also unambiguous. We also characterize the situation in which every unanimously unambiguous allocation is Pareto optimal. Finally, we show how our results can be used to explain the home-bias effect. As a useful result for our methods, we also obtain an additivity theorem for CEU and MEU decision makers that does not require comonotonicity.     

APEC: INTERNATIONAL TRADE AND OUTPUT

Abstract.  This paper estimates the effect that the APEC 'currency union', loosely defined, has on trade and, via trade, on output per capita. A gravity model is used to measure the impact of exchange-rate variability on trade flows within APEC. The gain in trade flows from eliminating nominal exchange-rate variability through the formation of a currency union is less than 1%. Furthermore, every 1% increase in trade (relative to GDP) raises income per capita by roughly 0.3% for twenty years. Adopting the dollar currency union is much more profitable than adopting a yen currency union for each country in APEC.     

THE SUITABILITY OF A GREATER CHINA CURRENCY UNION

Abstract. The study assesses the level of integration among the three Greater China economies (China, Hong Kong and Taiwan) and examines the suitability of a Greater China currency union. The three economies already have extensive trade and investment linkages. Our analyses show that they share common long‐run and short‐run cyclical variations. We also estimate the output costs of relinquishing policy autonomy to form a currency union. The estimated output losses, which depend on, e.g., the method used to generate shock estimates, seem to be moderate and are likely to be less than the efficient gains derived from a currency union.     

The effect of a currency union on trade: Lessons from the Irish experience

This paper studies the introduction of an exchange rate between Ireland and the UK in 1979 to shed light on the effects of a common currency on the composition of international trade. No evidence is found from time series or panel regressions that the change of exchange rate regime had a significant effect on Anglo-Irish trade. This finding is consistent with previous studies of currency unions between larger, developed countries but conflicts with findings based on more heterogeneous country groupings. The reasons for this discrepancy are discussed.     

PRODUCTIVITY MATTERS FOR TRADE POLICY: THEORY AND EVIDENCE*

In the growth literature that investigates the effect of trade liberalization on productivity, nearly all studies assume that trade policy is determined independently of productivity, and, hence, it is exogenous. I show, both theoretically and empirically, that this assumption is not valid in general. I find that in Colombia more productive sectors receive more protection and the sectors with higher productivity gains are liberalized less even in the presence of a large unilateral liberalization shock that affects all sectors. Researchers may be underestimating the positive effect of liberalization on productivity when they do not account for the endogeneity bias.     

Currency substitution,inflation, and welfare

Currency substitution affects the mapping between social welfare and inflation by altering the underlying money demand function and influencing interest rates. In order to explore the essence of this effect, I build a model with working capital under which foreign currency is substituted with the less liquid components of domestic money. The framework closely mimics the actual pattern of currency substitution across varying rates of inflation and enables the study of an additional channel that works through the impact of currency substitution on interest rates. It is found that there is a threshold inflation rate, which turns out to be 44% under baseline calibration, below which currency substitution decreases welfare and vice versa. A practical implication is that, at inflation rates lower (greater) than the threshold, the potential welfare gains from disinflation to a near-zero inflation rate are higher (lower) if there is currency substitution than otherwise.     

Balance Sheet Effects, Growth, and Crises

This paper addresses two questions: are currency crises predicted by increases in a central bank’s external and contingent liabilities relative to assets, and do these “balance sheet effects” generate persistent output losses following a crisis? I find empirical evidence that the answer to both questions is yes. I use data on stocks of gross external assets and liabilities for 167 countries over 1973–2003, in an unbalanced panel probit regression to obtain robust estimates of the probability and determinants of a post‐crisis recession. Several single and simultaneous equation specifications support the idea that the output cost of a currency crisis depends on its transmission mechanism. Specifically, a recession is likely to be severe if it is preceded by a crisis that works its way through the financial sector. In addition, the results show that measures of contingent liabilities, capital flight, and lack of financial depth are significant predictors of costly crises.     

Some Stylized Facts about International Trade Flows

Since the mid‐1990s there has been a proliferation of empirical models in the trade literature. Focus has ranged from the effect of particular explanatory variables to improved econometric techniques. However, there appears to be a lack of analyses on large international trade datasets aiming at describing the “stylized facts” of observed bilateral trade flows. Uncovering them is crucial as any empirical econometric model should reflect the basic properties of the data generating process. On the basis of a large panel dataset this paper finds that bilateral trade, despite being often unbalanced, tends to be reciprocal and persistent, and that the extensive margin of trade must not be disregarded. Moreover, bilateral trade flows are probably best modeled as a mixed panel of stationary and non‐stationary processes. The stationary vs non‐stationary separation of these flows, although not random, does not appear to be related to any common characteristics of the trading partners.     

CURRENCY UNIONS, TRADE FLOWS AND CAPITAL FLOWS

Abstract.  Trade within currency unions is much larger than outside of currency unions, even after factoring in many relevant variables. The existing empirical evidence is based on reduced form models of trade, and therefore indicates correlation between but neither causality nor mechanism. This paper argues that the causal relationship runs from currency unions to trade, and then considers two possible mechanisms behind this: currency union membership: reduces trade resistance or reduces investment resistance. We argue that both mechanisms are required to explain the observed economic impact of currency union membership.     

The evolution of east-west trade and the role of the Ecu in Eastern Europe

Conclusion This paper arrives at the conclusion that the expanding European Community is a dominant attraction for Eastern Europe, including the former USSR. Since the Community will have privileged trade arrangements with most, if not all, of Eastern Europe, optimal monetary solutions will be strongly influenced by trade relations. The future Western European currency therefore, is also playing a dominant role in the monetary choices of Eastern Europe. We have discussed several aspects of this choice (anchor of the exchange rate regime, management of foreign reserves, parallel currency and currency of a possible payments union) and conclude that the Ecu is the dominant contender.Opinions expressed in this paper are strictly personal.     

The synchronization of wage dynamics across EMU members. A test of the endogeneity hypothesis

We test the hypothesis of an endogenous currency area for the labor market of the Euro area: has the introduction of a common currency caused wage dynamics to become more synchronized and to be able to cushion for asymmetric shocks? Trade intensity, sector specialization and financial integration are tested for being the driving forces for the endogenous synchronization of wage dynamics. We use regression techniques with instrument variables, and find evidence of persistent asymmetries in nominal wage formation, despite a single currency and monetary policy. We explain the result with more specialization following financial integration, and with still existing differences in wage formation and labor market institutions. We conclude that the euro zone is not endogenous with respect to wage formation. Rather, there are incentives for beggar-thy-neighbor policies in the Euro area.     

Financial Market Imperfections and the Impact of Exchange Rate Movements on Exports*

This paper analyzes empirically the role of financial market imperfections in the way countries’ exports react to a currency depreciation. Using quarterly data for 27 developed and developing countries over the period 1990–2005, we find that the impact of a depreciation on exports will be less positive—or even negative—for a country if: (i) firms borrow in foreign currency; (ii) they are credit constrained; (iii) they are specialized in industries that require more external capital; (iv) the magnitude of depreciation or devaluation is large. This last result emphasizes the existence of a nonlinear relationship between an exchange rate depreciation and the reaction of a country's exports when financial imperfections are observed. This offers a new explanation for the consequences of recent currency crises in middle‐income countries.     

Currency depreciations and the U.S.–Italian trade balance: Industry-level estimates

As one of the indebted Southern European countries that have put pressure on the Euro in recent months, Italy would benefit from a reduction in its external trade deficit. One channel could be through a weakening of its currency—which would only work if the Euro depreciated against the currency of an outside importer, such as the U.S. dollar. This study examines the response of the trade balances of 106 individual industries to such depreciations, using annual data and applying cointegration analysis. We find that only 19 industries register a long-run improvement, with these concentrated in miscellaneous manufactures (SITC sector 8). Two major products in the automotive industry—petroleum and road motor vehicles, show evidence of a “J-curve” effect.