Currency Arrangements and Goods Market Integration: A Price Based Approach

Recent studies of the effect of currency arrangements on goods market integration (starting with Rose, 2000) employ a methodology based on volumes of trade. However, the connection between market integration and trade flows can be loose. In this paper, we adopt a different methodology that uses a 3-dimensional panel of prices of 95 very disaggregated goods (e.g., light bulbs) in 83 cities around the world from 1990 to 2000. We find that the impact of an institutionalized stabilization of the exchange rate, i.e., a currency board or a currency union, generally provides a stimulus to goods market integration that goes far beyond reducing exchange rate volatility to zero. However, there are important exceptions. Among the institutional arrangements, long-term currency unions demonstrate greater integration than more recent currency boards. All of them can improve their integration further relative to a U.S. benchmark.

The consequences of exchange rate volatility, and more generally, currency arrangements, are at the heart of open economy macroeconomics; yet professional opinion on their impact on goods market integration is divided. Witness the debate (and accompanying fanfare) surrounding the launching of the single European currency. Prominent among the skeptics, Feldstein (1997) argued that the euro would impose large costs upon its member countries without providing substantial economic benefits. This conclusion is based partly on his reading of the empirical literature up to 1997 that generally reported a small effect of exchange rate stabilization on trade volumes.

In contrast, a recent influential paper by Rose (2000), argues that adopting a common currency provides a substantial expansion of the volume of trade; an effect that goes beyond the impact of reducing exchange rate volatility to zero. Indeed, Rose estimates that the presence of a common currency increases bilateral trade among members by as much as 300% over what would be expected between otherwise identical countries. Frankel and Rose (2002), Engel and Rose (2001), Glick and Rose (2002), and Rose and van Wincoop (2001) have provided further extensions and support to this claim. Building on results in Frankel and Romer (1999), Frankel and Rose (2002) have gone on to argue that having a common currency provides a substantial boost to the member countries' output growth. For example, they estimate that dollarization would raise an average country's income by 4 percent over twenty years. On the other hand, this line of research has also attracted criticism. Persson (2001) and Tenreyro (2002) have suggested that the trade promotion effect of a common currency is greatly exaggerated due to the possibility of endogeneity of existing common currency areas, and Klein (2002) has argued that the basic results in Rose (2000) are not robust when the sample is restricted to certain sub-samples.