The Effect of Exchange Rate Variability and Different Types of Monetary Cooperation on Trade Flows.

Political leaders in Europe have long claimed that exchange rate cooperation is a prerequisite for effective trade integration. The euro is the ultimate manifestation of that argument. Economists recognize a clear functional link between exchange rates and trade flows, but they disagree about whether exchange rate variability significantly impedes trade in practice. Newer research by Rose and others suggests that currency unions, have a strong positive effect on trade, but these results rely on a limited definition of currency union. We re-examine Rose’s findings using his gravity model but a much larger dataset of dyadic relationships between independent countries since 1960. We replace his simple dummy variable representing a currency union with nuanced measures capturing different levels of monetary cooperation, including different types of exchange rate unions and currency unions. We also include measures of exchange rate variability to test whether monetary cooperation has an effect beyond the effect of fixed exchange rates. We find that while exchange rate variability has little to no effect on trade flows, monetary cooperation has a fairly large impact implying political factors are more important than economic ones. ..PAT.-Unpublished Manuscript [ABSTRACT FROM AUTHOR]