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Explaining the Euro's Effect on Trade? Interest Rates in an Augmented Gravity Equation

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Abstract

If the Euro has boosted intra Euro-Area trade, what exactly in the new currency is responsible for such an effect? Most explanations focus on a decrease in exchange rate volatility or in transaction costs, receiving mixed empirical support. After briefly surveying the relevant literature, this paper points to a novel channel of transmission: the sharp decrease in real interest rates that accompanied the Euro. The argument is that lower interest rates spurred investment spending and manufacturing value added, as in Flam and Helpman (1987), and induced a greater number for firms to enter the export market, ultimately boosting trade. This phenomenon is captured in a simple model with fixed costs, where the number of firms or varieties supported in a market is endogenous. The model is used to augment the traditional trade gravity equation. In the end, empirical results are presented in support of the interest rate's role at explaining the "Rose effect".

Suggested Citation

  • Tommaso Mancini Griffoli, 2006. "Explaining the Euro's Effect on Trade? Interest Rates in an Augmented Gravity Equation," IHEID Working Papers 10-2006, Economics Section, The Graduate Institute of International Studies.
  • Handle: RePEc:gii:giihei:heiwp10-2006
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    Cited by:

    1. Anderson, James E. & Vesselovsky, Mykyta & Yotov, Yoto V., 2016. "Gravity with scale effects," Journal of International Economics, Elsevier, pages 174-193.

    More about this item

    Keywords

    Gravity equation; International Trade; Common Currency; Instability tests in Panel data; Euro Area.;

    JEL classification:

    • F1 - International Economics - - Trade
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance
    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • C52 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Evaluation, Validation, and Selection

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