The Effect of Common Currency on Trade: Revisiting Rose's Debate

Title: “The Effect of Common Currency on Trade. Revisiting Rose's Debate” Authors Maria Santana-Gallego (Universidad de La Laguna) Francisco J. Ledesma-Rodríguez (Universidad de La Laguna) Jorge V. Pérez-Rodríguez (Universidad de Las Palmas) Objectives The main objective of this research is to revisit the estimation of the effect of a common currency on international trade. Rose (2000) estimates an empirical model of bilateral trade, finding a significant coefficient for a currency union variable of 1.2, suggesting an effect of currency unions on trade of over a 200%. Rose (2000)'s finding did not receive full acceptance and further research was consequently devoted to find reasons of such high effect. This still remains as a major puzzle in the International Economics. Rose and Van Wincoop (2001) hold that there may still be some omitted factors that drives countries to both participate in currency unions and trade more. In this research a gravity equation for trade is estimated controlling by international tourism. The omission of this regressor could have biased the estimates of the influence of the common currency on trade. Indeed business and leisure trips promote international trade in several ways (Santana et al, 2009). Data/Methods In the first step, a classical gravity equation is estimated by 2SLS-FE. A comparative analysis is carried out where tourism is included as one of the country effects- jointly with the traditional variables of the gravity equation such as GDP, population distance, common border, language, colonial ties and FTA, and it is observed whether the common currency effect on trade is reduced. In the second step, the approach proposed by Helpman et al (2008) (HMR) is used. The main advantage of this approach is that it is well-founded in the international trade theory. Furthermore, they proposed a two-stage estimation procedure where the problem of zero trade observations is addressed. In this research, tourism is recognized as a factor reducing both the fixed costs and the transport costs of serving a country. Dataset includes 164 destination countries and 200 origins (32800 pairs) for the period 1995-2006. Trade data are obtained from the IMF while tourism data are collected from the UNWTO. Results Preliminary results of the first step of the research suggest that the presence of tourism in the gravity equation reduces the effect of the common currency is reduced in a 5% for the whole sample but in a 40% for the OECD countries. The HMR estimation is expected to yield more accurate results by avoiding the zero-trade data bias. References Helpman, E., Melitz, M. and Y. Rubinstein (2008): “Estimating trade flows: trading partners and trading volumes”, Quarterly Journal of Economics, Vol. CXXIII, pp. 441-487. Rose, A.K. (2000): “One money, one market: Estimating the effect of common currencies on trade”. Economic Policy 20, pp. 9-45. Rose A.K. and E. Van Wincoop (2001): "National money as a barrier to trade". American Economic Review 91, No. 2, pp. 386-390. Santana, M., Ledesma, F.J., and Pérez, J.V. (2009). “Exchange Rate Regimes and Tourism”. Tourism Economics, forthcoming.