Skip to main content
SpringerLink
Log in

Trade implications of the Euro in EMU countries: a panel gravity analysis

  • Original Paper
  • Published:
Empirica Aims and scope Submit manuscript

Abstract

In this paper, we study the intra-EMU and intra-Eurozone trade effects of the euro adoption on 29 European Economic and Monetary Union countries (including 17 Eurozone economies and Iceland) from the period 1994 through 2011. We employ a generalized gravity model that controls for an extended set of trade theory and policy variables. The gravity model is estimated using the robust panel data techniques that includes times effects, besides country-specific effects. The various econometric specifications of the gravity equation, on the whole dataset of 29 economies, yield positive and significant impact (to be around 14 %) of the euro currency adoption on bilateral trade flows. Next, euro effect on bilateral trade and exports on a smaller dataset is estimated. The estimated results suggest that bilateral trade and exports increase by 20.81 and 18.57 %, respectively, when both the countries belong to the Eurozone. This effect is larger than the one obtained when only one of the two trading partners uses the euro as its currency. In addition, the validity of the assumptions of Heckscher–Ohlin (H–O) theory are checked for the countries under study. The estimated results reject the H–O theory in favor of Modern Trade theories. However, the low value of the coefficient on respective variable suggests that, over the period, the type of trade among these countries has transited from inter-industry trade to horizontal intra-industry trade. This suggests that these developed European economies are on the path of economic convergence via intra-industry trade.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Fig. 1
Fig. 2
Fig. 3
Fig. 4

Similar content being viewed by others

Notes

  1. For an extensive summary of the various OCA criteria, see Broz (2005).

  2. Although adopted in 1999, the euro was physically introduced in 2002.

  3. By the joining of Latvia to the Euro-zone on January 1, 2014 and Lithuania on January 1, 2015, the number of countries using the euro as its currency has increased to 19.

  4. A one-way FEM permits each cross-sectional unit to have its own constant term while the slope estimates of β are constrained across units, as is the \( \sigma_{\varepsilon }^{2} \). The estimator is termed as least-squares dummy-variable (LSDV) estimator, since it is equivalent to including N − 1 dummy variables in the OLS regression. More specifically, it can be shown to equal the estimator obtained from OLS estimation of \( y_{it} on \, {\mathbf{x}}_{it} \quad \, and \, \quad N \) individual-specific indicator variables \( d_{j,it} , \, \quad j = 1, \ldots ,N \), where \( d_{j,it} , = 1 \) for the ith observation if j = 1, and \( d_{j,it} , = 0 \) otherwise. Then, the fitted model becomes \( y_{it} = \left( {\sum\nolimits_{j = 1}^{N} {\alpha_{i} } d_{j,it} } \right) + {\mathbf{x}}_{it}^{\prime } \beta + \varepsilon_{it} \). However, this equivalence of LSDV and within estimators does not carry over to nonlinear models. Besides, the name LSDV is fraught with problems because it implies an infinite number of parameters in our estimation. A better way to understand the FE estimator is to see that removing panel-level averages from each side of (1) removes the FE from the model, as shown in the methodology part.

  5. Another type of estimator, the between estimator, is less efficient because it discards the over-time information in the data in favor of simple means, as it is the OLS estimator from the regression of \( \bar{y}_{i} \, on \, {\bar{\mathbf{x}}}_{i} \).

  6. In contrast to the FEM (where inference is conditional on the FE in the sample), inference from the REM pertains to the underlying population of individuals because the REM identifies the population parameters that describes the individual-level heterogeneity. Therefore, a REM is more efficient and allows a broader range of statistical inference. However, the key assumption that \( \mu_{i} \) is uncorrelated with the regressors can and should be tested.

  7. As can be seen, RE estimator has pooled OLS (θ = 0) and within estimation (θ = 1) as special cases. The RE estimator approaches the within estimator as T gets large and as \( \sigma_{\mu }^{2} \) gets large relative to \( \sigma_{\varepsilon }^{2} \), because in those cases \( \theta \to 1 \). To the extent that θ differs from 0, pooled OLS will be inefficient, as it will attach too much weight on the between units variation, attributing it all to the variation in \( {\mathbf{x}} \) rather than apportioning some of the variation to the differences in \( \varepsilon_{i} \) across units.

  8. The modern theory of optimum currency areas has shifted its priority from nature and characteristics of an economy to the level of economic development of an economy in judging optimality. In the light of this argument, we preferred per capita GDP to GDP and, hence, retained only per capita GDP variable in our gravity model.

  9. Iceland and Croatia were included being on Exchange Rate Management (ERM II).

  10. Column 4 (two-way FEM) of Table 2 gives the parameter of CU dummy equal to 0.136. Therefore, the increase in bilateral trade induced by the adoption of the euro by euro member countries is [{e 0.136×1 − e 0.136×0} × 100] = 14.57 %.

References

  • Aitken ND (1973) The effect of the EEC and EFTA on European trade: a temporal cross-section analysis. Am Econ Rev 63:881–892

    Google Scholar 

  • Alesina A, Barro RJ (2002) Currency unions. Q J Econ 117(2):409–436

    Article  Google Scholar 

  • Anderson JE (1979) A theoretical foundation for the gravity equation. Am Econ Rev 69(1):106–116

    Google Scholar 

  • Anderson JE, Wincoop E (2003) Gravity with gravitas: a solution to the Border puzzle. Am Econ Rev 93(1):170–192

    Article  Google Scholar 

  • Anderson JE (2010) The gravity model. NBER Working Paper 16576

  • Anderson JE, Vesselovsky M, Yotov YV (2013) Gravity, Scale and Exchange Rates. NBER Working Paper 18807

  • Baier SL, Bergstrand JH (2007) Do free trade agreements actually increase members’ international trade? J Int Econ 71(1):72–95

    Article  Google Scholar 

  • Baldwin RE, Skudelny F, Taglioni D (2005) Trade effects of the euro: evidence from sectoral data. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=668246

  • Baldwin R, Taglioni D (2006) Gravity for dummies and dummies for gravity equations. NBER Working Paper 12516

  • Baldwin R, DiNino V, Fontagne L, De Santis RA, Taglioni D (2008) Study on the impact of the euro on trade and foreign direct investment. Economic Paper 321. Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission

  • Baltagi B (2008) Econometric analysis of panel data. Wiley, London

    Google Scholar 

  • Barr D, Breedon F, Miles D (2003) Life on the outside: economic conditions and prospects outside euroland. Econ Policy 18(37):573–613

    Article  Google Scholar 

  • Barro RJ, Gordon DB (1983) Rules, discretion and reputation in a model of monetary policy. J Monet Econ 12(1):101–121

    Article  Google Scholar 

  • Barro R, Tenreyro S (2007) Economic effects of currency unions. Econ Inq 45(1):1–23

    Article  Google Scholar 

  • Berger H, Nitsch V (2008) Zooming out: the trade effect of the Euro in historical perspective. J Int Money Finance 27(8):1244–1260

    Article  Google Scholar 

  • Bergin PR, Lin CY (2012) The dynamic effects of a currency union on trade. J Int Econ 87(2):191–204

    Article  Google Scholar 

  • Bergstrand JH (1985) The gravity equation in international trade: some microeconomic foundations and empirical evidence. Rev Econ Stat 67(3):474–481

    Article  Google Scholar 

  • Blanchard O, Wolfers J (2000) The role of shocks and institutions in the rise of European unemployment: the aggregate evidence. Econ J 110(462):1–33

    Article  Google Scholar 

  • Broz T (2005) The theory of optimum currency areas: a literature review. Privredna Kretanja I Ekonomska Politika 104:53–78

    Google Scholar 

  • Buiter WH (1995) Macroeconomic policy during a transition to monetary union. CEPR Working Paper No. 1222

  • Buiter WH (2000) Optimal currency areas: Why does the exchange rate regime matter? (with an Application to UK Membership in EMU). Centre for Economic Performance, London School of Economics and Political Science

  • Bun MJG, Klaassen FJGM (2002) The importance of dynamics in panel gravity models of trade. Retrieved from http://dare.uva.nl/record/393045

  • Bun MJG, Klaassen FJGM (2007) The Euro effect on trade is not as large as commonly thought*. Oxford Bull Econ Stat 69(4):473–496

    Article  Google Scholar 

  • Buti M, Suardy M (2000) Cyclical convergence or differentiation? Insights from the first year of EMU. Revue de La Banque 64(2/3):164–172

    Google Scholar 

  • Cafiso G (2008) The Euro’s influence upon trade: Rose effect versus Border effect. European Central Bank. http://www.suomenpankki.fi/pdf/160530.pdf

  • Calvo GA, Reinhart CM (2002) Fear of floating. Q J Econ 117(2):379–408

    Article  Google Scholar 

  • Camarero M, Gómez E, Tamarit C (2014) Is the “euro effect“on trade so small after all? New evidence using gravity equations with panel cointegration techniques. Econ Lett 124(1):140–142

    Article  Google Scholar 

  • Cameron AC, Trivedi PK (2009) Microeconometrics using stata, vol 5. Stata Press, College Station

    Google Scholar 

  • Cieślik A, Michalek JJ, Mycielski J (2012) Measuring the trade effects of the Euro in Central and Eastern Europe. J Int Trade Econ Dev 21(1):25–49

    Article  Google Scholar 

  • Collins SM (1996) On becoming more flexible: exchange rate regimes in Latin America and the Caribbean. J Dev Econ 51(1):117–138

    Article  Google Scholar 

  • Cordon WM (1972) Monetary integration. International Finance Section, Princeton University. http://www.getcited.org/pub/101321427

  • De Grauwe P (1996) The economics of convergence: towards monetary union in Europe. Weltwirtschaftliches Arch 132(1):1–27

    Article  Google Scholar 

  • De Grauwe P (1988) Exchange rate variability and the slowdown in growth of international trade. Staff Pap Int Monet Fund 35:63–84

    Article  Google Scholar 

  • De Grauwe P (2006) What have we learnt about monetary integration since the maastricht treaty? J Common Mark Stud 44(4):711–730

    Article  Google Scholar 

  • De Grauwe P, Skudelny F (2000) The impact of EMU on trade flows. Weltwirtschaftliches Arch 136(3):381–402

    Article  Google Scholar 

  • De Grauwe P, Mongelli FP (2005) Endogeneities of optimum CURRENCY AREas: What brings countries sharing a single currency closer Together? Departamento de Economia, Gestão e Engenharia Industrial, Universidade de Aveiro

  • De Grauwe P (2014) Economics of monetary union. Oxford University Press, Oxford

    Google Scholar 

  • De Nardis S, Vicarelli C (2003) Currency unions and trade: the special case of EMU. Rev World Econ 139(4):625–649

    Article  Google Scholar 

  • De Nardis S, De Santis R, Vicarelli C (2008) The Euro’s effects on trade in a dynamic setting. Eur J Comp Econ 5(1):73–85

    Google Scholar 

  • De Sousa J (2012) The currency union effect on trade is decreasing over time. Econ Lett 117(3):917–920

    Article  Google Scholar 

  • Deardorff A (1998) Determinants of bilateral trade: Does gravity work in a neoclassical world? In: Frankel JA (ed) The regionalization of the world economy. University of Chicago, Chicago, pp 7–32

    Google Scholar 

  • Dellas H, Tavlas GS (2009) An optimum-currency-area odyssey. J Int Money Finance 28(7):1117–1137

    Article  Google Scholar 

  • Edwards S (1996) Exchange rates and the political economy of macroeconomic discipline. Am Econ Rev 86(2):159–163

    Google Scholar 

  • Egger P (2000) A note on the proper econometric specification of the gravity equation. Econ Lett 66(1):25–31

    Article  Google Scholar 

  • Egger P, Pfaffermayr M (2003) The proper panel econometric specification of the gravity equation: a three-way model with bilateral interaction effects. Empir Econ 28(3):571–580

    Article  Google Scholar 

  • Engel C, Rose AK (2000) Currency Unions and International Integration. NBER Working Paper 7872

  • Faruqee H (2004) Measuring the trade effects of EMU. IMF Working Paper 04/154, International Monetary Fund, Washington

    Google Scholar 

  • Fidrmuc J (2004) The endogeneity of the optimum currency area criteria, intra-industry trade, and EMU enlargement. Contemp Econ Policy 22(1):1–12

    Article  Google Scholar 

  • Fidrmuc J, Fidrmuc J (2003) Disintegration and trade. Rev Int Econ 11(5):811–829

    Article  Google Scholar 

  • Flam H, Nordström H (2003) Trade volume effects of the Euro: aggregate and sector estimates. IIES Seminar Paper 746. Institute for International Economic Studies, Stockholm

  • Fidrmuc J (2009) Gravity models in integrated panels. Empir Econ 37(2):435–446

    Article  Google Scholar 

  • Frankel JA, Rose AK (1997) Is EMU more justifiable ex post than ex ante? Euro Econ Rev 41(3):753–760

    Article  Google Scholar 

  • Frankel JA, Rose AK (1998) The endogeneity of the optimum currency area criteria. Econ J 108(449):1009–1025

    Article  Google Scholar 

  • Gandolfo G (1992) Monetary unions. In: Newman P, Milgate M, Eatwell J (eds) The new palgrave dictionary of money and finance, vol 3. MacMillan, London, pp 765–770

    Google Scholar 

  • Geldi HK (2012) Trade effects of regional integration: a panel cointegration analysis. Econ Model 29(5):1566–1570

    Article  Google Scholar 

  • Glick R, Rose AK (2002) Does a currency union affect trade? The time-series evidence. Euro Econ Rev 46(6):1125–1151

    Article  Google Scholar 

  • Grubel HG (1970) The theory of optimum currency areas. Can J Econ 3(2):318–324

    Article  Google Scholar 

  • Havránek T (2010) Rose effect and the euro: Is the magic gone? Rev World Econ 146(2):241–261

    Article  Google Scholar 

  • Head K, Mayer T (2002) Illusory border effects: distance mismeasurement inflates estimates of home bias in trade, vol 1. CEPII, Paris

    Google Scholar 

  • Helpman E, Melitz M, Rubinstein Y (2008) Estimating trade flows: trading partners and trading volumes. Q J Econ 123(2):441–487

    Article  Google Scholar 

  • Hooper P, Kohlhagen SW (1978) The effect of exchange rate uncertainty on the prices and volume of international trade. J Int Econ 8(4):483–511

    Article  Google Scholar 

  • Ishiyama Y (1975) The theory of optimum currency areas: a survey. Staff Papers-IMF, pp 344–83

  • Issing O (2001) Monetary policy in the Euro area: strategy and decision-making at the European Central Bank. Cambridge University Press, Cambridge

    Book  Google Scholar 

  • Kenen PB (1969) The optimum currency area: an eclectic view. In: Mundell R, Swoboda AK (eds) Monetary problems of the international economy. University of Chicago Press, Chicago, pp 41–60

    Google Scholar 

  • Krugman PR (1993) What do we need to know about the international monetary system? International Economics Section, Department of Economics, Princeton University

  • Krugman PR (2001) Lessons of Massachusetts for EMU. Int Libr Crit Writ Econ 134:41–61

    Google Scholar 

  • Kydland FE, Prescott EC (1977) Rules rather than discretion: the inconsistency of optimal plans. J Political Econ 85(3):473–491

    Article  Google Scholar 

  • Linnemann H (1966) An econometric study of international trade flows. North-Holland Publishing Company, Amsterdam. http://library.wur.nl/WebQuery/clc/457015

  • Martinez-Zarzoso I (2013) The log of gravity revisited. Appl Econ 45(3):311–327

    Article  Google Scholar 

  • McKinnon R (1963) Optimum currency areas. Amer Econ Rev 717–25

  • Melitz J (1991) Brussels on a single money. Open Econ Rev 2(3):323–336

    Article  Google Scholar 

  • Micco A, Stein E, Ordoñez G (2003) The currency union effect on trade: early evidence from EMU. Econ Policy 18(37):315–356

    Article  Google Scholar 

  • Mundell RA (1961) A theory of optimum currency areas. Am Econ Rev 51:657–665

    Google Scholar 

  • Mundell RA (1973) Uncommon arguments for common currencies. In: The economics of common currencies: proceedings of the Madrid conference on optimum currency areas. Allen & Unwin, pp 114–32

  • Nitsch V (2002) Honey, I shrunk the currency union effect on trade. World Econ 25(4):457–474

    Article  Google Scholar 

  • Obstfeld M, Rogoff K (1996) Exchange rate dynamics redux. NBER Working Paper 4693

  • Pöyhönen P (1963) A Tentative model for the volume of trade between countries. Weltwirtschaftliches Arch 90(1):93–100

    Google Scholar 

  • Rault C, Sova R, Sova AM (2009) modelling international trade flows between CEEC and OECD countries. Appl Econ Lett 16(15):1547–1554

    Article  Google Scholar 

  • Rose AK et al (2000) One money, one market: the effect of common currencies on trade. Econ Policy 15(30):7–46

    Article  Google Scholar 

  • Roy J (2014) On the robustness of the trade-inducing effects of trade agreements and currency unions. Empir Econ 47(1):253–304

    Article  Google Scholar 

  • Siliverstovs B, Schumacher D (2009) Estimating gravity equations: To log or not to log? Empirical Econ 36(3):645–669

    Article  Google Scholar 

  • Santos Silva JMC, Tenreyro S (2006) The log of gravity. Rev Econ Stat 88(4):641–658

    Article  Google Scholar 

  • Tavlas GS (1993) The ‘new’ theory of optimum currency areas. World Econ 16(6):663–685

    Article  Google Scholar 

  • Tinbergen J (1962) Shaping the world economy: suggestions for an international economic policy. Twentieth Century Fund, New York

    Google Scholar 

  • Tower E, Willett TD (1976) The theory of optimum currency areas and exchange-rate flexibility. International Finance Section, Department of Economics, Princeton University

  • Westerlund J, Wilhelmsson F (2011) Estimating the gravity model without gravity using panel data. Appl Econ 43(6):641–649

    Article  Google Scholar 

Download references

Acknowledgments

The authors are very grateful to Ministry of Minority Affairs, Government of India, for funding this research work. The authors are also thankful to Dr. Wasim Ahmad and Ajay Kumar Sahoo for their help from time to time. We also present our special thanks to Prof. Sushant K. Mallick (University of London) and Dr. Ranajoy Bhattacharyya (IIFT, Kolkata Campus) for their views and helpful comments on the study. The earlier versions of this paper were presented at the International Conference on “Global Economic Crisis, Macroeconomic Dynamics, and Development Challenges of Developing Countries” held at Centre for Jawaharlal Nehru Studies, Jamia Millia Islamia University, New Delhi (24–25 Feb. 2014) and at the Two Day National Seminar on “Applications of Panel Data” held, between 25th to 26th of March 2014, in collaboration with The Indian Econometric Society (TIES) at Centre for Economic and Social Studies (CESS), Hyderabad, India.

Author information

Authors and Affiliations

  1. School of Management, The Northcap University, Gurgaon, 122017, India

    Mohd Hussain Kunroo

  2. School of Humanities and Social Sciences, Indian Institute of Technology, Indore, Madhya Pradesh, 453331, India

    Irfan Ahmad Sofi

  3. Department of Economics, Jamia Millia Islamia University, New Delhi, 110025, India

    Mohd Hussain Kunroo & Naushad Ali Azad

Authors
  1. Mohd Hussain Kunroo
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Irfan Ahmad Sofi
    View author publications

    You can also search for this author in PubMed Google Scholar

  3. Naushad Ali Azad
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Mohd Hussain Kunroo.

Appendix: List of control dummy variables used in the model

Appendix: List of control dummy variables used in the model

All the economic variables that affect trade between the two trading partners are explicitly included in the model. Besides these standard set of gravity variables, there exist a set of control variables that may affect the bilateral trade (such as geographic location, contiguity, landlockedness, historical ties, regional trading agreements and customs union, colonial ties, similarity in cultural, political, and legal institutions, etc.). These variables are classified as economic geography and historical ties variables. Economic geography variables include contiguity and landlocked location. Contiguity may stimulate cross-border trade, while landlocked location may discourage trade between two countries due to lack of sea access. Historical ties variables include common colonial past, common official language, etc. Since our dataset includes only European Union countries, therefore inclusion of variables like colonial ties variable is not required. The included control variables are

  • \( CONTGTY_{ijt} \): dummy variable whose value is equal to 1 if countries i and j share common border in year t and 0 otherwise.

  • \( COMLANGO_{ijt} \): 1 for the common official primary language between country i and country j in year t; 0 otherwise.

  • \( COMLANGE_{ijt} \): 1 if a language is spoken by at least 9 % of the population in both the countries in year t; 0 otherwise.

  • \( LANDLKDI_{it} \): dummy variable whose value is equal to 1 if reporting country i is a landlocked country and partner country j is not in year t and 0 otherwise.

  • \( LANDLKDII_{jt} \): dummy variable whose value is equal to 1 if country i is not a landlocked country but country j is a landlocked country in year t; 0 otherwise.

  • \( LANDLKD_{ijt} \): dummy variable whose value is equal to 1 if both the countries are landlocked in year t and 0 otherwise.

Rights and permissions

Reprints and permissions

About this article

Check for updates. Verify currency and authenticity via CrossMark

Cite this article

Kunroo, M.H., Sofi, I.A. & Azad, N.A. Trade implications of the Euro in EMU countries: a panel gravity analysis. Empirica 43, 391–413 (2016). https://doi.org/10.1007/s10663-016-9334-6

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10663-016-9334-6

Keywords

JEL Classification

Search

Navigation