Currency Unions and their Effect on Trade Andrew K. Rose UC Berkeley, NBER and CEPR

Question What is the effect of currency union on international trade? Answer Large

Motivation All agree that expansion of trade only unambiguous gain of EMU Most other benefits possible via other means This gain thought to be small Exchange rate volatility has small effect on trade

A Typical Study Large panel data set: annual data for 217 “countries” Use bilateral “gravity” model of trade Find effects of creating/dissolving currency unions are large Entering CU doubles (leaving halves) bilateral trade

Gravity Model ln(X ijt ) =  0 +  1 lnD ij +  2 ln(Y i Y j ) t +  3 ln(Y i Y j /Pop i Pop j ) t +  4 Lang ij +  5 Cont ij +  6 Landl ij +  7 Island ij +  8 ln(Area i Area j ) +  9 ComCol ij +  10 CurCol ijt +  11 Colony ij +  12 ComNat ij +  13 FTA ijt + γCU ijt, +  t  t T t +  ijt where i and j denotes trading partners, t denotes time. Estimation: OLS with year effects, dyadic fixed effects, robust standard errors Parameter of Interest: 

Data Set Trade data from IMF’s Direction of Trade Real US $ 217 trading entities, most global trade covered (with gaps) Average (4 measures of) bilateral exports and imports PWT, WDI, IFS for population, GDP CIA’s website

What is Currency Union? Money interchangeable between countries at 1:1 par for extended period of time (no need to convert prices) Fixed exchange rates don’t qualify EMU as just one (recent) example

Many Currency Unions pre-EMU CFA Franc zone (15 West Africans) ECCA (8 Caribbeans) Panama, Ecuador, Guatemala, El Salvador use US dollar Many others (Pacific, South Africa, Europe, …)

Event Studies

Dissolution of Currency Union

Estimation Results γ=.65 (standard error =.05) Big effect: exp(.65)-1 =.92 Currency Union almost doubles trade!

More Studies Special Focus on EMU Euro only physically introduced in 2002 Still, Micco, Stein & Ordonez find large positive effects of EMU

Small Literature Now Exists 34 studies estimate effect of currency union on trade Summing over all 34 using “meta- analysis” gives large positive effect Trade rises by between 30% and 90%

Remaining Mysteries Is EMU Different Not so far, but very early Why is the effect of Currency Union on trade so big?