Lessons From NAFTA: Discussing the Merits of a Free Trade Agreement as a Precursor to a Currency Union

Abstract

In the early 1990’s, the announcement of NAFTA forever changed the landscape of the North American Economy. This study analyzes the impact of this landmark policy decision on the business cycles and output forecast variances of the United States, Mexico, and Canada, examining these metrics before and after the NAFTA announcement. This study finds that NAFTA increased trade and business cycle correlations between all of the countries, with a very significant increase in the correlation between the United States and Mexico. This study also performs a forecast variance decomposition analysis and finds that after the NAFTA announcement, output variance of Mexico and Canada became more explained by the United States, and less explained by their own economies. This study places these findings in the conversation of optimal currency area theory, and suggests that a free trade agreement could be an effective policy measure for prospective currency union candidates to implement in advance of forming a currency union.