Question: what is the effect of a common currency on international trade? Answer: large. So began Andrew Rose's lunchtime meeting, held in London on 6 October 2000. Rose had used a large cross-country panel data set in order to show that countries with the same currency trade over three times more with each other than comparable countries with their own currencies.

The increase in trade stemming from a common currency is one of the few undisputed gains from EMU: substituting a single currency for several national ones eliminates exchange rate volatility and reduces the transaction costs of trade within the group of countries. Yet most commentators (and most economists?) believe that EMU's effect on trade will be reasonably small – this is certainly the view of commentators in The FT and The Economist. First, exchange rate volatility was low before EMU and could be inexpensively hedged with the use of forward contracts and derivatives. And second, most economists assume that a common currency is equivalent to reducing exchange rate volatility to zero. Although, intuitively at least, the elimination of currency variations should tend to increase trade, the empirical literature on this subject has not found a consistent relationship – even in those papers that do find a negative relationship between volatility and trade, it is generally weak.

Yet, Rose argued, a single currency and zero exchange rate volatility are not synonymous: sharing a common currency is a much more serious and durable commitment than a fixed exchange rate. So it is surprising that until now this issue has not been addressed. It is still too early to assess the effect on trade for the EMU 11, but there is no reason to rely on European before and after data to quantify the consequences of a shared currency; the world is full of currency unions. In addition to the EMU 11, 91 'countries' are currently in some kind of official common currency scheme - 32 of these are official dependencies or territories. Hence Rose exploits cross-sectional variation, using evidence across countries, to trace the effects of both currency unions and exchange rate volatility.

Rose used the gravity model of international trade (one of the few empirical models in economics that works consistently well) to isolate the individual determinants of the level of bilateral trade between two countries. The equation is estimated using a data set with 33,903 bilateral trade observations from 186 'countries' for five different years – 1970, 1975, 1980, 1985, 1990. 330 of the observations involve two countries using the same currency. The dependent variable is bilateral trade flows. The independent variables are GDP, GDP per capita, distance between countries, and dummy variables for a common language, a land border, membership of a regional trade agreement and past colonial ties. In addition to these, Rose added the standard deviation of the percentage change in the bilateral nominal exchange rate and a dummy variable for a common currency.

Estimating this equation with ordinary least squares gives reasonable results. Higher GDP and GDP per capita increase trade, whereas the greater the distance between the two countries reduces trade. These three effects are usually found in traditional gravity models: Rose's estimates are similar in magnitude and statistically significant. Sharing a language, a land border, a regional trade agreement or a shared colonial past also increases trade by economically and statistically significant amounts. Yet above and beyond all of these real factors, Rose finds compelling evidence that the international monetary regime matters.

Holding all other factors constant, countries with a common currency trade much more than comparable countries with different currencies. This effect is economically large and statistically significant: the estimated parameter for the common currency dummy variable is 3.35 – i.e. countries with the same currency trade approximately three and a half times as much with each other as countries with different currencies. Exchange rate volatility is found to exert a small negative effect on trade. Specifically, reducing exchange rate volatility from its average level to zero would increase trade by approximately 13%. Hence Rose's estimates seem to distinguish a currency union from zero exchange rate volatility quite markedly: entering a currency union delivers an effect approximately 25 times larger than eliminating exchange rate movements.

The results of the model are robust. Rose had estimated the equation over 60 different ways, using different samples, different ways of measuring the exchange rate and currency union variables, different estimation methods and different specifications of the gravity model. All of these robustness checks confirm that the general results do not depend on the exact way the equation is specified or estimated. Rose also conducted a robustness check that allowed exchange rate volatility to be modelled as an endogenous variable, since countries may try to reduce exchange rate volatility in order to stimulate trade. Even after allowing for this feedback, the strong effect of currency unions on trade remains.

Rose conceded that even he had found the scale of his results surprising. Yet, he argued, when viewed in the context of trade within countries rather than between countries, the result seems far more feasible. Trade within countries is huge compared with trade between countries. McCallum (1995) found that a typical Canadian province trades 22 times more with other provinces than with US states of similar size and distance. Countries have a number of important factors that encourage commercial trade, such as a common legal system, common cultural norms, common history, in addition to a common currency. In this sense, a tripling of trade from a currency union alone seems plausible.

Rose had emphasized throughout that to concentrate on the scale of the result was missing the point. Even if his model had overestimated the effects by a factor of seven, a 50% increase in trade is still highly significant. Recent estimates suggest that increasing the ratio of trade to GDP by one percentage point raises income per person by 0.5-2%. Given potential gains of this magnitude, trade need not triple for a common currency to induce large welfare gains.

Rose concluded that if a common currency does substantially increase trade, then there will be important repercussions. There may be an increase in trade disputes and frictions simply because the volume of international trade rises. These will certainly occur inside Europe because of EMU (as competitive pressures lead special interests to cry out for protectionism) and may also occur between Europe and the rest of the world. Although a common currency can create trade, it may also divert trade away from low-cost non-European producers to less efficient European ones. As a result, there may be pressures to maintain, or even increase, the social safety net both in and out of Europe. Furthermore, an increase in trade could not only increase the benefits of a currency union but may also reduce its costs: Rose argued that, historically, closer international trade between countries has been associated with more synchronized business cycles, which will reduce the incidence of asymmetric shocks.

The decision to enter a currency union is based on many criteria, nearly all of which Rose had ignored. Still, the idea that trade increases because of a single currency is far from contentious. The magnitude of the increase is, however, highly contentious. The vast majority of economists believe the effect to be small, based on arguments involving the effect of eliminating exchange rate volatility. The case for a common currency is weaker accordingly. Rose had contended in his talk that such scepticism was unwarranted, in that a potent argument in favour of currency unions had been understated in the literature. Even after taking a number of other considerations into account, countries that share a common currency engage in substantially higher international trade, he said.