Estimating the Effect of Currency Unions on Trade and Output

Gravity-based cross-sectional evidence indicates that currency unions stimulate trade; cross-sectional evidence indicates that trade stimulates output. This paper estimates the effect that currency union has, via trade, on output per capita. We use economic and geographic data for over 200 countries to quantify the implications of currency unions for trade and output, pursuing a two-state 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. Our estimates at the second stage suggest that every one percent increase in trade (relative to GDP) raises income per capita by roughly 1/3 of a percent over twenty years. We combine the two estimates to quantify the effect of currency union on output. Our results support the hypothesis that the beneficial effects of currency unions on economic performance come through the promotion of trade, rather than through a commitment to non-inflationary monetary policy, or other macroeconomic influences.