Explaining the Euro's Effect on Trade? Interest Rates in an Augmented Gravity Equation

If the Euro has boosted intra Euro-Area trade, what exactly in the new currency is responsible for such an effect? Most explanations focus on a decrease in exchange rate volatility or in transaction costs, receiving mixed empirical support. After briefly surveying the relevant literature, this paper points to a novel channel of transmission: the sharp decrease in real interest rates that accompanied the Euro. The argument is that lower interest rates spurred investment spending and manufacturing value added, as in Flam and Helpman (1987), and induced a greater number for firms to enter the export market, ultimately boosting trade. This phenomenon is captured in a simple model with fixed costs, where the number of firms or varieties supported in a market is endogenous. The model is used to augment the traditional trade gravity equation. In the end, empirical results are presented in support of the interest rate's role at explaining the "Rose effect".Gravity equation, International Trade, Common Currency, Instability tests in Panel data, Euro Area.

Limits to arbitrage during the crisis: funding liquidity constraints and covered interest parity

Arbitrage normally ensures that covered interest parity (CIP) holds. Until recently, excess profits, if any, were documented to last merely seconds and reach a few pips. Instead, this paper finds that following the Lehman bankruptcy, these were large, persisted for months and involved strategies short in dollars. Profits are estimated by specifying the arbitrage strategy as a speculator would actually implement it, considering both unsecured and secured funding. Either way, it seems that dollar funding constraints kept traders from arbitraging away excess profits. The claim finds support in an empirical analysis drawing on several novel high frequency datasets of synchronous quotes across securities, including transaction costs.arbitrage limits, covered interest parity, funding liquidity, financial crisis

Monetary Policy with Endogenous Firm Entry and Sticky Entry Costs

This paper builds a monetary model where firm entry is endogenous, thereby exposing a new channel for the transmission of monetary policy. Individuals have a choice between consuming or investing in new firms by financing a sunk entry cost. Monetary policy shocks affect the cost-benefit analysis of creating new firms, and generate persistent as well as hump-shaped responses of consumption, investment, output and new firm entry, as observed in the data. These results lie on an endogenous source of inertia and are obtained despite minimal nominal rigidities, as only entry costs are assumed to be sticky.Monetary policy, firm entry, sunk entry costs, investment, sticky prices, New Keynesian models.

Is There a Euro Effect on Trade? An Application of End-of-Sample Structural Break Tests for Panel Data

Whether trade has increased due to the Euro is a question at the heart of lively policy debates and academic research. We revisit the question with a new, more powerful econometric test for end-of-sample breaks to formally identify the timing and duration of the structural break implied by the ÒRose effectÓ on the Euro AreaÕs trade. We find a significant break in 1999Q1 when using a traditional gravity equa- tion, corroborating the general consensus in the literature. However, we find that this break is short lived. Furthermore, we show that the break can be explained both by the marked decrease in real interest rates across the Euro Area and by deepening European institutional integration.Gravity equation, International Trade, Common Currency, Structural break tests in panel data, Euro Area

Stability tests for heterogeneous panel data

This paper proposes a new test for structural instability in heterogeneous panels. The test builds on the seminal work of Andrews (2003) originally developed for time series. It is robust to non-normal, heteroskedastic and serially correlated errors, and allows for the number of post break observations to be small. Importantly, the test considers the alternative of a break affecting only some - and not all - individuals of the panel. Under mild assumptions the test statistic is shown to be asymptotically normal, thanks to the additional cross sectional dimension of panel data. This greatly facilitates the calculation of critical values. Monte Carlo experiments show that the test has good size and power under a wide range of circumstances. The test is then applied to investigate the effect of the Euro on trade.structural change ; end-of-sample instability tests ; heterogeneous panels ; Monte Carlo ; Euro effect on trade

Stability Tests for Heterogeneous Panel Data

This paper proposes a new test for structural instability in heterogeneous panels. The test builds on the seminal work of Andrews (2003) originally developed for time series. It is robust to non-normal, heteroskedastic and serially correlated errors, and allows for the number of post break observations to be small. Importantly, the test considers the alternative of a break affecting only some - and not all - individuals of the panel. Under mild assumptions the test statistic is shown to be asymptotically normal, thanks to the additional cross sectional dimension of panel data. This greatly facilitates the calculation of critical values. Monte Carlo experiments show that the test has good size and power under a wide range of circumstances. The test is then applied to investigate the effect of the Euro on trade.Structural change, end-of-sample instability tests, heterogeneous panels, Monte Carlo, Euro effect on trade.

Stability tests for heterogeneous panel data

This paper proposes a new test for structural instability in heterogeneous panels. The test builds on the seminal work of Andrews (2003) originally developed for time series. It is robust to non-normal, heteroskedastic and serially correlated errors, and allows for the number of post break observations to be small. Importantly, the test considers the alternative of a break affecting only some - and not all - individuals of the panel. Under mild assumptions the test statistic is shown to be asymptotically normal, thanks to the additional cross sectional dimension of panel data. This greatly facilitates the calculation of critical values. Monte Carlo experiments show that the test has good size and power under a wide range of circumstances. The test is then applied to investigate the effect of the Euro on trade.Ce papier propose un nouveau test pour détecter des changements structurels en fin d'échantillon dans des panels hétérogènes. Le test se construit sur le travail de Andrews (2003) conçu à l'origine pour des données temporelles. Le test est robuste à des erreurs non normales, hétéroscédastiques et autocorrélées. De plus, il permet au nombre d'observations suivant le changement structurel d'être petit. Le test considère l'hypothèse alternative que le changement structurel affecte seulement certains individus. Malgré des suppositions générales, la statistique du test est distribuée telle une normale. Cette propriété facilite grandement le calcul de valeurs critiques. Des résultats d'expériences de type Monte Carlo démontrent les excellentes propriétés du test. Pour finir, l'utilisation du test est illustré dans une évaluation de l'impact de l'Euro sur le commerce européen

Discussion: The Swiss Franc Exchange Rate and Deviations from Uncovered Interest Parity: Global vs Domestic Factors

NoneCurrency risk; exchange rate; save haven effects; uncovered interest parity (UIP)