An Estimate of the Effect of Common Currencies on Trade and Income

Abstract

Gravity-based cross-sectional evidence indicates that currency unions and currency boards stimulate trade; cross-sectional evidence indicates that trade stimulates income. This paper estimates the effect that common-currency regimes have, via trade, on income per capita. We use economic and geographic data for over 200 countries to quantify the implications of common currencies for trade and income, pursuing a two-stage approach. Our estimates at the first stage suggest that belonging to a currency union more than triples trade with the other members of the zone. Moreover, there is no evidence of trade-diversion. Thus currency unions raise overall trade. Currency boards have similar effects. Our estimates at the second stage suggest that every one percent increase in trade (relative to GDP) raises income per capita by at least one third of a percent over twenty years. We combine the two estimates to quantify the effect of common currencies on output. Our results support the hypothesis that the beneficial effects of such regimes on economic performance come through the promotion of trade, rather than through a commitment to non-inflationary monetary policy, or other macroeconomic influences.