Reconsidering the Trade-Creating Effects of the Currency Union

Countries select particular exchange rate arrangements for a variety of reasons. For example, the ability to conduct an independent monetary policy is often cited as the main advantage of having a floating exchange rate regime. Conversely, countries sometimes tie their exchange rate to that of a larger country—foregoing the ability to conduct independent monetary policies—to benefit from the relative stability of the foreign currency. This is the rationale for several Latin American countries that have recently adopted or are considering policies of dollarization. A more prevalent rationale for adopting fixed exchange rates or even common-currency arrangements, however, is the notion that exchange rate volatility introduces uncertainty into cross-border transactions, reducing the volume of trade that would otherwise take place. Indeed, this argument played a key role in the decision of the European Union to embark upon plans for introducing the euro. As described in an early EU Green Paper on the subject: