Handbook of Exchange Rates

28.2 Econometric Evidence on the Bilateral Trade Effects of Currency Regimes

Economists began to take much more seriously the possibility that fixed exchange rates encourage trade with the publication of Andrew Rose's 2000 paper, “One Money, One Market…,” perhaps the most influential empirical international economics paper of its decade. Applying the gravity model to a bilateral data set that was sufficiently large to encompass a number of currency unions led to an eye-opening finding: members of currency unions traded with each other an estimated three times as much as with otherwise-similar trading partners. Even if Rose had not included the currency union dummy, this paper would still have been important because he had bilateral exchange rate variability on the list of variables explaining bilateral trade, and it was highly significant statistically.⁵ But the attention grabber was that the currency union dummy had a far larger, and highly significant effect, above and beyond the effect of bilateral variability per se. This chapter was of course motivated by the coming of EMU in 1999, even though estimates were necessarily based on historical data from (much smaller) countries who had adopted currency unions in the past.

Rose's remarkable tripling estimate has been replicated in various forms many times. But no sooner had he written his paper than the brigade to “shrink the Rose effect”⁶—or to make it disappear altogether—descended en masse. These critiques sometimes read to ...