FRBSF Economic Letter
2000-03; February 4, 2000
 Economic
Letter Index
Do Currency Unions Increase Trade? A "Gravity" Approach
In 1999, eleven European nations created a common currency zone, known
as the European Economic and Monetary Union (EMU). These countries have
relinquished national monetary control and adopted the euro as their official
currency. The EMU is one of several currency unions in the world. Furthermore,
in recent weeks, Ecuador--acting unilaterally--has seriously contemplated
abandoning its national money and adopted the U.S. dollar, a move that
Argentina, Mexico, and Canada also are considering.
Increased trade is one of the few undisputed gains from a currency union.
Substituting a single currency for several national currencies eliminates
exchange rate volatility and reduces the transactions costs of trade within
that group of countries. Thus trade can be expected to rise. The question
is: How much?
This question has not been addressed in the literature, which is curious,
since the number of currency unions is large. For instance, fifteen African
countries use the CFA franc, and eight Caribbean countries belong to the
East Caribbean Currency Area (see Rose 1999 for a complete list of countries
with common currency arrangements). Most research has focused instead
on the effects of exchange rate volatility on international trade. For
example, in the case of the euro, most economists believe that trade will
increase only slightly, since exchange rate volatility was low before
the EMU was formed, and since whatever volatility remained could be inexpensively
hedged through the use of forward contracts and other derivatives. Indeed,
econometric investigations of the impact of exchange rate volatility on
international trade have never found a big negative effect.
This Economic Letter presents results based on research that
directly explores the effect of currency unions on international trade
using a "gravity" model (Rose 1999). This study shows that the effect
of currency unions is large. I use a large cross-country data set to show
that two countries with the same currency trade much more than comparable
countries with their own currencies--over three times as much. While reducing
exchange rate volatility also increases trade, the effect of a common
currency is much larger than that of eliminating exchange rate volatility
but retaining separate currencies.
The "gravity" model
My objective is to link cross-country variation in currency arrangements
to cross-country variation in international trade. Of course, many things
affect trade other than international monetary relations. While these
other factors are not of direct interest here, I need to model their effects
to see if there is any remaining role for exchange rate volatility and/or
currency unions. Ordinarily, this would be difficult in economics. But
in this context, there is a simple and persuasive model in which I can
embed the objects of interest: the "gravity" model of international trade.
The gravity model is a very simple empirical model that explains the
size of international trade between countries. It models the flow of international
trade between a pair of countries as being proportional to their economic
"mass" (read "income") and inversely proportional to the distance between
them. The gravity equation acquired its name since a similar function
describes the force of gravity in physics.
The gravity model has a remarkably consistent history of success as an
empirical tool. The elasticities of trade with respect to both income
and distance are consistently signed correctly, economically large, and
statistically significant in an equation that explains a reasonable proportion
of the cross-country variation in trade. An embarrassing number of theories
claim the empirical success of the gravity model as their own, so the
gravity model also has theoretical credentials.
The regression model I use to explain trade includes the income of the
two countries, the distance between them, and a host of extra variables.
These account for the effects of physical contiguity (if two countries
share a common land border), common language, membership in a common regional
trade agreement like NAFTA, colonial past, and the like.
To this set-up, I add two extra variables. One is a binary dummy variable,
which is one if the two countries share a common currency (like Panama
and the U.S., or Belgium and Luxembourg) and zero otherwise. The other
is exchange rate volatility, measured as the standard deviation of the
percentage change in the bilateral nominal exchange rate.
I estimate my equation using a data set with 33,903 bilateral trade observations
for five different years (1970, 1975, 1980, 1985, and 1990). All 186 entities
("countries") for which the United Nations Statistical Office collects
international trade data are included in the data set (see Rose 1999).
In this sample, I have 320 observations where two countries trade and
use the same currency.
The trade data are taken from the World Trade Database. This
data set is estimated to cover 98% of all trade. I pool the data across
years, deflating nominal trade values (measured in dollars) by the GDP
price index and include year controls. I use the Penn World Table
5.6 for population and real GDP per capita data.
The gravity model's performance
When I estimate my equation with ordinary least squares, I find that
the model works well. Both higher GDP and higher GDP per capita for the
country pair increase trade. The greater the distance between two countries,
the lower their trade. All three of these traditional gravity effects
are intuitively reasonable, similar in magnitude to existing estimates,
and statistically significant. Sharing a land border, a language, or a
regional trade agreement also increases trade by economically and statistically
significant amounts. The equations fit the data well, explaining over
half of the variation in bilateral trade linkages.
Above and beyond all of these real factors, I find compelling evidence
that the international monetary regime matters. Countries that use the
same currency tend to trade disproportionately, even holding the real
factors constant. The effect is economically large; indeed, it is larger
than the effect of being in a common regional trade agreement. My point
estimate is that countries with the same currency trade three times
as much with each other as countries with different currencies! Without
taking this estimate too literally, it seems clear that trade is substantially
higher for countries that use the same currency, holding other things
equal. Countries with volatile exchange rates also trade less. Both effects
are significant at conventional statistical levels.
To date, most economists have presumed that a common currency is equivalent
to reducing exchange rate volatility to zero. Is this assumption reasonable?
No. The effects of currency unions and exchange rate volatility are not
only precisely estimated, but economically distinguishable. Hypothetically
reducing exchange rate volatility from its average level to zero would
increase trade by around 10%. That is, entering a currency union delivers
an effect that is 35 times--over an order of magnitude--larger than the
impact of reducing exchange rate volatility from its average level to
zero.
To summarize, the gravity equation works well: it fits the data well
and delivers precise reasonable estimates. These bolster my confidence
in the three main findings. First, there is an intuitive negative effect
of exchange rate volatility on trade. A more novel finding is the large
positive effect of a common currency on trade. Third, the effect of a
common currency is much larger than the hypothetical effect of reducing
exchange rate volatility to zero.
In Rose (1999), I include a large amount of sensitivity analysis. I estimate
my equation over 40 different ways, using different samples, different
ways of measuring my exchange rate and currency union variables, different
estimation methods, and different specifications of the gravity model.
All these robustness checks confirm that my key results do not depend
delicately on the exact way that my equation is specified or estimated.
I also conducted a robustness check that allowed exchange rate volatility
to be modeled as an endogenous variable. This is important, since countries
may try to reduce exchange rate volatility in order to stimulate trade.
I found that, even after allowing for this feedback, the strong effect
of currency unions on trade remains.
Implications of increased trade for the
EMU
It seems clear that a common currency should encourage trade. The puzzle
is that the effect seems to be so enormous. Why does sharing a currency
have such a big effect on trade? The short answer is: I don't know. Perhaps
it is because a common currency represents a serious government commitment
to long-term integration. This commitment could, in turn, induce the private
sector to engage in greater international trade. Or perhaps hedging exchange
rate risk is much more difficult than commonly believed. Alternatively,
a common currency could induce greater financial integration, which then
leads to stronger trade in goods and services. Still, it is wisest to
conclude that we simply don't know why a common currency seems to facilitate
trade so much.
Nevertheless, even if we don't know why a common currency makes
a difference, it is plausible that it does. The evidence in this
paper has separated the common currency component from the other characteristics
that differentiate within-country intranational trade from cross-country
international trade. The evidence of intranational bias is clear;
trade within countries is simply huge compared to trade between countries,
even for well-integrated areas like the European Union. Countries have
a number of important aspects for commercial trade, including common cultural
norms, a common legal system, and so forth. A common currency is a piece
of this package; and it seems to be an important piece.
Does this effect matter? Yes. The most important consequence of increased
trade is increased gains from trade. As the deadweight loss of using different
currencies vanishes, competitive pressures increase and consumers gain.
The size of these gains may be large. There may also be dynamic gains
if extra trade causes growth rates to increase. And if the EMU causes
radically increased intra-European trade and its benefits, other countries
may well take the plunge, spreading these gains even further.
A large increase in trade precipitated for whatever reason (including
the introduction of a common currency) brings benefits but also tensions.
Certainly there may be an increase in trade disputes. These will certainly
occur inside Europe because of the EMU, as competitive pressures lead
special interests to cry for protectionism. There may be an increase in
trade tensions between Europe and the rest of the world if the European
market size increases dramatically. A common currency may create much
trade, but it also will divert trade from low-cost non-European producers
to less efficient European producers who benefit from being in the EMU.
As a result, there will be pressures to retain (or even increase) the
social safety net both inside and outside Europe.
Conclusion
In the research summarized here, I have used the gravity model to show
that two countries with a common currency trade much more than comparable
countries with their own currencies. The effect is statistically significant
and economically large; my point estimate is over 300% as much. The impact
of a common currency is an order of magnitude larger than the effect of
reducing moderate exchange rate volatility to zero but retaining separate
currencies. The effect takes into account a variety of other factors and
seems robust. Since most economists believe that the effect of a common
currency on trade is small, a potent argument in favor of currency unions
has been underappreciated.
Andrew K. Rose
Visiting Scholar, FRBSF, and
Professor of Economic Analysis and Policy, UC Berkeley
Reference
Rose, Andrew K. 1999. "One
Money, One Market: Estimating the Effect of Common Currencies on Trade"
(available at http://haas.berkeley.edu/~arose).
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