Essays on currency unions and trade

The countries constituting a currency union (a group of countries sharing a common currency) are thought to be more integrated among themselves than are other countries. A common currency is thought to increase trade by eliminating costs associated with exchanging currencies and hedging against exchange rate risk. The existing literature has concluded that the increase in intra-union trade arising from the common currency ranges from 92% to 266% (Glick and Rose (2002)). My first chapter revisits these findings by regressing gravity equations using aggregate trade data and allowing for heterogeneous trade responses across currency unions. Only some currency unions are as integrated as was previously believed. Surprisingly, the currency union effects are positively correlated with tariffs on goods traded within the union: the higher the tariff, the greater the incentive for importers to avoid foreign exchange costs by purchasing within the union. Therefore, the common currency does not lower trade costs directly but becomes the means by which importers reduce total trade costs in the presence of high tariffs. To understand better the results described above, the second chapter uses the disaggregated gravity equation of Anderson and Yotov (2010) to show that the common currency reduces trade costs differently for different goods. A common currency has a larger effect on trade in certain types of manufactured goods than on trade in agricultural goods. Trade within the Eurozone and US Dollar zone consists of agricultural goods while trade within the currency unions in Africa and the Caribbean consists of manufactured goods. The third chapter proposes an alternative metric to evaluate the extent of integration within a currency union. This chapter examines whether or not the theory of Purchasing Power Parity (PPP) linking price levels and long-run exchange rates holds within currency unions. Using the cointegration methods of Johansen (1995), I find that PPP holds for a few unions and is sensitive to the time period examined and the currency union’s composition. Even in unions where PPP holds, PPP fails to hold for several country pairs within the union, undermining the ability of the union to survive in the long run