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

Tommaso Mancini Griffoli ()
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Tommaso Mancini Griffoli: IUHEI, The Graduate Institute of International Studies, Geneva

No 10-2006, IHEID Working Papers from Economics Section, The Graduate Institute of International Studies

Abstract: 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".

Keywords: Gravity equation; International Trade; Common Currency; Instability tests in Panel data; Euro Area. (search for similar items in EconPapers)
JEL-codes: C23 C52 F1 F4 (search for similar items in EconPapers)
Pages: 33
Date: 2006-05
New Economics Papers: this item is included in nep-cba, nep-eec, nep-ifn and nep-int
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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