Analysis of the impact of exchange rate regimes on trade flows: A panel data analysis

Recent research on exchange rate regimes has been focused on the effect of currency unions on international trade flows. The beliefs about the performance in terms of inflation and growth are decisive in the choice of the exchange rate regime. Furthermore, the effect of the exchange rate regime on the international trade is another argument commonly considered to support the exchange rate policy. In this way, less flexible exchange rates are expected to promote international trade via reduced uncertainty in the international transactions, eliminated some transaction costs and enhanced transparency of the markets.

However, the empirical literature is not conclusive to that respect. As surveyed by McKenzie (1999) and more recently by Ozturk (2006), the evidence about the effect of less exchange rate volatility on trade is mixed and the results are sensitive to the choice of sample period, model specification, proxies for exchange rate volatility and countries considered. In contrast to this inconclusive link, an influential article by Rose (2000) estimates a very large effect of a currency union on trade and suggests that fixed exchange rate regimes could affect trade performance. According to their results, members of currency unions seemed to trade over three time as much as otherwise pair of countries. This result is surprisingly large and has received little acceptance among the researchers.

Then, it seems to exist contradictory results about the effect of exchange rate volatility and sharing a common currency, i.e. zero volatility. These could be indicating that exchange rate volatility is not a good proxy for exchange rate risk and exchange rate regime may be more suitable. To that respect, few papers in the literature have analysed the effect of exchange rate regimes on trade (Klein and Shambaugh, 2006; Adam and Cobham, 2007; Qureshi and Tsangarides, 2010 and Santana-Gallego, 2011). In general, these authors found that fixed exchange rate regimes, currency unions and pegs, promote trade.

In the present paper, a gravity equation for bilateral exports between pairs of countries is used. A large sample which includes data for 194 countries for the period 1950 to 2011 is considered to study the impact of different exchange rate regimes on trade flows. To define the variables of interest, the updated “de facto” exchange rate classification of Iletzky, Reinhart and Rogoff is considered to define five exchange rate regime dummy variables: Currency unions, Pegs, crawling pegs, crawling bands and managed floating. Moreover, in our analysis the case of the euro as both, common currency and anchor currency for pegs, crawling pegs and crawling bands, is considered