An Estimate of the Effect of Currency Unions

Gravity-based cross-sectional evidence indicates that currency unions stimulate trade as much or more than do free trade areas. Thus currencies are a source of the home-country bias in trade. This paper extends such findings to estimate the ultimate benefits of currency unions, via trade, in terms of income per capita. We use a large data set of economic and geographic variables for over 200 countries and dependencies to quantify the implications of currency unions for trade and growth, pursuing a two-stage approach. Our estimates at the first stage suggest that a currency union more than triples trade with the partners in question. Our estimates at the second stage suggest that every one percent increase in trade (relative to GDP) raises income per capita by roughly 1/3 of a percent over a 20-year period. We combine the two estimates to derive a prediction for the effects of currency union on growth. Our results support the hypothesis that the beneficial effects of currency unions on economic performance come specifically through the promotion of trade or other interactions with major trading partners, rather than, as commonly thought, through a commitment to non-inflationary monetary policy, or other macroeconomic influences. JEL Classification Numbers: F11 F33 O40 * This paper was written for the Conference on Currency Unions, organized by Alberto Alesina and Robert Barro, Hoover Institution, Stanford University, May 19-20, 2000. Jeffrey A. Frankel is Harpel Professor and Director of the NBER program in International Finance and Macroeconomics. Andrew K. Rose is Rocca Professor, Research Associate of the NBER, and Research Fellow of the CEPR. The data sets and a current version of the paper are available at Rose’s web site.