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 over time. First, empirical work with data from the European Monetary Union finds that the extensive margin of trade (entry of new firms or goods) responds several years ahead of overall trade volume and actual implementation of the monetary union. This implies a fall at the intensive margin (previously traded goods) in the run-up to EMU. A dynamic stochastic general equilibrium model of trade studies the announcement of a future monetary union as a news shock lowering future trade costs, and finds that the early entry of new firms in anticipation is explainable as a rational forward-looking response under certain conditions. Required elements are sunk costs of exporting and ex-ante heterogeneity among firms. The findings help identify which types of trading frictions are reduced by adopting a currency union. Findings also indicate that a significant fraction of the welfare gains from a monetary union are based upon expectations for the future, so that continued gains depend upon long-term credibility of the union.