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

This 2000 Economic Policy paper by Andrew Rose asks a simple question – does sharing a currency boost trade, and by how much – using a large cross-country panel rather than the handful of time-series studies that had previously found little effect of exchange-rate variability on trade. Rose estimates an augmented gravity model of bilateral trade, adding income, population, distance, a common land border, a common language, a regional trade agreement, colonial history, and common nationhood to the usual gravity regressors, then adds a currency-union dummy and a measure of bilateral exchange-rate volatility, on a panel of 186 countries and dependent territories spanning five benchmark years (1970, 1975, 1980, 1985, 1990) and over 33,000 country-pair observations, including more than 300 observations in which both countries use the same currency. The headline finding is that exchange-rate volatility has the expected small negative effect on trade, but sharing a currency is associated with a far larger, economically enormous increase in trade: the point estimate implies that two countries using the same currency trade over three times as much as two otherwise-identical countries with separate currencies, an effect Rose shows is more than an order of magnitude larger than the estimated gain from eliminating exchange-rate volatility entirely. The result survives an extensive battery of robustness checks – alternative samples (excluding intra-developing-country pairs, excluding major “key-currency” countries, excluding whole regions, excluding highly asymmetric income or size pairs), alternative measures of currency union and exchange-rate volatility, alternative distance and language measures, ten different sets of additional controls for omitted variables, alternative estimators (Tobit, weighted least squares, Heckman selection, random effects, quantile and robust regression), a trade-growth specification, and an instrumental-variables approach using inflation-rate instruments to address possible reverse causality from trade to exchange-rate volatility. Rose is explicit that the paper cannot explain why the estimated effect is so large relative to the small transaction-cost savings usually assumed to be at stake, and that as a reduced-form gravity exercise it cannot deliver a structural welfare number – but concludes that the trade, and likely the welfare, benefits of currency unions have been substantially underestimated in the existing literature.

Economic Policy | Macro Paper Warehouse

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