DP2987 Geography, Trade and Currency Union

Author(s): Jacques Melitz
Publication Date: October 2001
Keyword(s): bilateral trade, free trade area, geography, gravity, monetary union, trade creation, trade diversion
JEL(s): F10, F33
Programme Areas: International Macroeconomics, International Trade and Regional Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=2987

This Paper reports on four basic results of tests of the standard gravity equation. First, geography can serve to reflect comparative advantage as well as transportation costs. Second, the effect of distance on bilateral trade is mostly a substitution effect between closer and more distant trade partners rather than a scale effect on total foreign trade. Third, special political relationships, such as free trade agreements, former colonial attachments, and currency union, do not produce any trade diversion in the aggregate, but increase trade with outsiders as well as among the parties to the relationship. Fourth, Rose?s surprisingly high estimate of the impact of currency union on trade stems partly from a selection bias, but even following a correction for this bias, the estimate remains high.