The dynamic effects of a currency union on trade

The response of trade to a monetary union is a dynamic process. An empirical study of the European monetary union finds that the extensive margin of trade in new goods responded several years ahead of EMU implementation and ahead of overall trade volume. A dynamic rational expectations trade model shows that early entry of new firms in anticipation is explainable as a rational forward-looking response to news. The model helps identify which types of trading frictions are reduced by a currency union, and shows how new entry can be affected by uncertainty about EMU. ► The response of trade to a monetary union is a dynamic process. ► The extensive margin of trade in new goods responded several years ahead of EMU. ► Early entry is explainable as a rational forward-looking response to news. ► A reduction in proportional trade costs imply dynamics consistent with the empirics.