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

Abstract:

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 more than 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.