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Economic effects of currency unions

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  • Robert J. Barro
  • Silvana Tenreyro

Abstract

This paper develops a new instrumental-variable (IV) approach to estimate the effects of different exchange rate regimes on bilateral outcomes. The basic idea is that the characteristics of the exchange rate regime between two countries (exchange rate variability, fixed or float, autonomous or common currencies) are partially related to the independent decisions of these countries to peg -explicitly or de facto- to a third currency, notably that of a main anchor. Our approach is to use this component of the exchange rate regime as an IV in regressions of bilateral outcomes. We illustrate the methodology with one specific application: the economic effects of currency unions. The likelihood that two countries independently adopt the currency of the same anchor country is used as an instrument for whether they share or not a common currency. Three findings stand out. First, sharing a common currency enhances trade, supporting previous work by Rose [2000]. Second, a common currency increases price co-movements; this finding is consistent with the observation that a large part of the variation in real exchange rates is caused by fluctuations in nominal exchange rates. Finally, a common currency decreases the co-movement of shocks to real GDP. This is consistent with the view that currency unions lead to greater specialization.

Suggested Citation

  • Robert J. Barro & Silvana Tenreyro, 2002. "Economic effects of currency unions," Working Papers 02-4, Federal Reserve Bank of Boston.
  • Handle: RePEc:fip:fedbwp:02-4
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    References listed on IDEAS

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    1. Frankel, Jeffrey A & Rose, Andrew K, 1998. "The Endogeneity of the Optimum Currency Area Criteria," Economic Journal, Royal Economic Society, vol. 108(449), pages 1009-1025, July.
    2. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121.
    3. Rose, Andrew, 1999. "One Money, One Market: Estimating the Effect of Common Currencies on Trade," Seminar Papers 678, Stockholm University, Institute for International Economic Studies.
    4. Alberto Alesina & Robert J. Barro, 2002. "Currency Unions," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 409-436.
    5. James E. Anderson & Eric van Wincoop, 2001. "Borders, Trade and Welfare," Boston College Working Papers in Economics 508, Boston College Department of Economics.
    6. Hallak, Juan Carlos, 2006. "Product quality and the direction of trade," Journal of International Economics, Elsevier, vol. 68(1), pages 238-265, January.
    7. Robert J. Barro & Silvana Tenreyro, 2006. "Closed and Open Economy Models of Business Cycles with Marked Up and Sticky Prices," Economic Journal, Royal Economic Society, vol. 116(511), pages 434-456, April.
    8. Frankel, Jeffrey A & Rose, Andrew K, 2000. "An Estimate of the Effect of Currency Unions on Trade and Output," CEPR Discussion Papers 2631, C.E.P.R. Discussion Papers.
    9. Jeffrey Frankel & Andrew Rose, 2002. "An Estimate of the Effect of Common Currencies on Trade and Income," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 437-466.
    10. Andrew K. Rose & Eric van Wincoop, 2001. "National Money as a Barrier to International Trade: The Real Case for Currency Union," American Economic Review, American Economic Association, vol. 91(2), pages 386-390, May.
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    More about this item

    Keywords

    Foreign exchange;

    JEL classification:

    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • F1 - International Economics - - Trade

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