Economic Effects of Currency Unions

By Barro, Robert; Tenreyro, Silvana | Economic Inquiry, January 2007 | Go to article overview

Economic Effects of Currency Unions


Barro, Robert, Tenreyro, Silvana, Economic Inquiry


I. INTRODUCTION

A vast empirical literature in international finance investigates the effects of exchange rate regimes on different economic outcomes. For example, several studies have analyzed the effect of exchange rate variability on bilateral trade, foreign direct investment, and relative prices. Other studies have focused on the differential effects of pegged-versus-fixed exchange rates (including stricter forms of fixed exchange rate regimes, such us currency boards or currency unions). The underlying assumption in most studies is that exchange rate regimes are randomly assigned and, hence, exogenous to the outcome variable under study. Standard endogeneity problems, however, can hide the true effect of exchange rate regimes in simple ordinary least square (OLS) estimates. For example, the choice of exchange rate regimes might reflect omitted characteristics that can also influence the economic outcome. Similarly, the adoption of a certain regime might come with other (unmeasured) policies that also affect the outcome.

The first contribution of this paper is to develop an instrumental-variable (IV) approach to address the endogeneity problem present in the estimation of the effects of exchange rate regimes on economic variables, such as bilateral capital flows, trade volumes, and comovement of business cycles. As an illustration, consider two countries that exhibit a low extent of exchange rate variability between them. There are several reasons for this low variability. Some reasons might be related to the deliberate decision of facilitating trade between the two countries, leading to a bias in OLS estimates of the effect of exchange rate variability on the volume of bilateral trade. (1) Another reason, however, might be related to the independent decisions of these two countries to keep a close parity with a third country's currency. In this case, the level of exchange rate variability between the two countries will be exogenous to their bilateral trade. The methodology proposed in this study exploits this triangular relationship with third countries to identify the economic effect of different exchange rate regimes or features of exchange rate regimes (e.g., variability) on bilateral outcomes. In particular, following this example, the methodology isolates the motive for low (or high) variability that relates to the objective of pegging to a third currency and uses this motivation as an IV for the extent of variability.

While the methodology developed in this paper can be applied to the analysis of different exchange rate arrangements, we illustrate it here with one specific application: the effect of currency unions on bilateral trade and on the extent of comovement of output shocks and price shocks.

Assessing the economic effects of currency unions is imperative, given the recent developments in international monetary arrangements. Twelve Western European countries have recently instituted the euro as their common currency. Sweden, Denmark, and Britain have opted out, but they might join in the near future. Several Eastern European countries are debating the unilateral adoption of the euro as legal tender. Ecuador fully dollarized its economy; El Salvador and Guatemala legalized the use of the U.S. dollar, and other governments in South and Central America are giving serious consideration to dollarization. Six West African states are considering the adoption of a common currency, and 11 members of the Southern African Development Community are debating whether to adopt the U.S. dollar or to create an independent currency union possibly anchored to the South African rand. (2) Finally, six oil-producing countries have expressed their intention to form a currency union by 2010. (3)

A number of recent papers estimate the effect of currency unions on bilateral trade. Most notably, Rose (2000) and Frankel and Rose (2002) report that bilateral trade between two countries that use the same currency is, controlling for other effects, over 200% larger than bilateral trade between countries that use different currencies. …

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