The Currency Union Effect on Trade: The Role of Financial Development

Messer, Walker Lee (2014) The Currency Union Effect on Trade: The Role of Financial Development. Undergraduate thesis, under the direction of Dr. Joshua R. Hendrickson from Economics, University of Mississippi.

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Abstract

The effect of currency union formation on trade growth may depend on an economy’s level of financial development. Economies with lower levels of financial development have less capacity to hedge exchange rate risk, are susceptible to hysteresis, and have little to overcome the large fixed costs of entering foreign markets. These barriers may be partially overcome through the use of common currencies. Economies with high levels of financial development may already be capable of overcoming these barriers to trade and will likely not gain significant trade from common currency formation. This paper tests the hypothesis that the currency union effect on trade varies across levels of financial development using gravity model data from Glick and Rose (2001) and over 219,000 observations of financial development between 1960 and 1997. The findings of this research support the paper’s hypothesis and motivate important policy considerations for nations contemplating common currency formation.

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