Exchange rate variability, international trade and monetary cooperation in Europe: some quantitative evidence for the single currency debate

Exchange rate variability is claimed to have adverse effects on foreign trade. We focus on exchange rate variability over long periods, which may affect trade through either uncertainty or political economy channels. Previous theoretical studies have found that the trade effects of uncertainty may be negative or positive. We argue that the trade outcome of political economy effects is likewise indeterminate. Accordingly, empirical investigation is necessary to determine the trade effects of exchange rate variability. We conduct two studies of trade amongst developed market economies and find that long-run exchange rate variability reduces both the level and growth of trade. However, our results also suggest that trade benefits not only from reduced variability but also from institutionalized regime shift from floating to fixed exchange rates and on to a single currency. In addition, we find that: 1. political economy effects are not a necessary condition for exchange rate variability to depress trade; 2. uncertainty effects are a sufficient condition for this result; and 3. dynamic trade effects come from adjustment to EU membership rather than from membership as such.