Exchange Rate Regimes and the Extensive Margin of Trade

Abstract

This paper finds that currency unions and direct exchange rate pegs raise trade through distinct channels. Panel data analysis of the period 1973-2000 indicates that currency unions have raised trade predominantly at the extensive margin, the entry of new firms or products. In contrast, direct pegs have worked almost entirely at the intensive margin, increased trade of existing products. A stochastic general equilibrium model is developed to understand this result, featuring price stickiness and firm entry under uncertainty. Because both regimes tend to reliably provide exchange rate stability over the horizon of a year or so, which is the horizon of price setting, they both lead to lower export prices and greater demand for exports. But because currency unions historically are more durable over a longer horizon than pegs, they encourage firms to make the longer-term investment needed to enter a new market. The model predicts that when exchange rate uncertainty is completely and permanently eliminated, all of the adjustment in trade should occur at the extensive margin.