July 1, 2008
A multilateral currency union removes the intraregional exchange rates but not the union rate variability with the rest of the world. The intraregional exchange rate variability is thus latent. A two-step procedure is developed to measure the variability. The measured variables are used to model inflation and intraregional trade growth of individual union members. The resulting models form the base for counterfactual simulations of the union impact. Application to ASEAN+3 shows that the intraregional variability consists of mainly short-run shocks, which have significantly affected the inflation and trade growth of major ASEAN+3 members, and that a union would reduce inflation and promote intraregional trade on the whole but the benefits facing each member vary and may not be significant enough to warrant a vote for the union.
J.E.L classification codes: F02, F40, O19, O53
Keywords:Currency union, Latent variables, Dynamic factor model, Simulation