The Dynamic Effects of Currency Union on Trade

A currency union’s ability to increase international trade is one of the most debated questions in international macroeconomics. This paper studies the dynamics of these trade effects. As empirical motivation, we find that the extensive margin of trade (entry of new firms or goods) in the eurozone responded several years prior to implementation of the European monetary union. The paper studies the announcement of a future monetary union as a news shock to trade costs in the context of a two-country dynamic stochastic general equilibrium model. We study the conditions under which one should see entry of new firms in anticipation of the new regime; we find that this requires both sunk costs of exporting and heterogeneity among firms of a type that is known before the sunk cost is paid. Without this firm heterogeneity, the expectation for entry by other firms in future periods eliminates the expected future profits needed to motivate early entry in periods of lower profits prior to the new policy regime. A conventional model of learning by doing will not generate this result. The important role of expectations also indicates that continued gains from EMU depend upon long-term credibility of the monetary union, a finding with significant consequences given recent events in Europe. The findings also help identify which types of trading frictions are reduced by a currency union.