Positive OCA Criteria: Microfundations for the Rose Effect

Abstract

Since Rose (2000), many scholars have found empirical evidence linking trade to exchange rate volatility and currency unions. Our paper takes a first step toward providing theoretical underpinnings for this "Rose effect". In our Melitz-like trade model, reduced volatility boosts trade by inducing existing exporters to export more and by inducing more firms to begin exporting. Specifically, volatility is a greater hindrance to export for small firms, so reduced volatility especially promotes small firms' exports. Because most firms are small, the extra exports induced by a marginal reduction in volatility may increase as the level of volatility falls - a result that can account for the convexity of the trade-volatility link implied by the Rose effect. We derive and test three new empirical hypothesis generated by our model. We find some support for two of them using data on Eurozone aggregate bilateral trade, but have insufficient data to test the third in a convincing manner.

Keywords: OCA, Monetary Union, Heterogeneity, Trade

JEL Classification: F1, F0