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What is the link between economic integration and business cycle synchronization among countries?

Focusing on the business cycle criteria of the optimal currency area (OCA), this paper analyses the effects of trade integration on the synchronisation of supply and demand shocks between the European Union (EU) and ten candidate Central and Eastern European countries (CEECs) over the past decade. (Eight of these countries acceeded the EU in 2004. )

Major findings are:

• higher trade intensity and lower exchange rate volatility increase demand shock convergence
• the effect of higher integration on the supply shock asymmetry varies from country to country
• the impact of trade integration on shock asymmetry depends on the type of shock
• in terms of demand shocks, countries are more likely to satisfy the criteria for monetary union membership ex post, as economic integration deepens
• on the supply side, the link between shock asymmetry and trade integration is ambiguous - higher trade intensity may be accompanied by both supply shock symmetry and asymmetry.

One interpretation of the results is that pegging national currencies to the euro or even entering the EMU would not be so costly for the candidate countries in terms of the costs associated with demand shock asymmetry. Indeed, the EU candidate countries are characterised by levels of supply and demand shock asymmetries comparable to those for present EU member countries such as Ireland, Portugal, and Spain. However, the author notes that a closed economy approach does not allow researchers to distinguish between domestic and foreign shocks. Therefore, one may observe more convergence or more symmetry than in the case of “pure domestic” shocks.

Finally, the author points out that:

• the importance of the OCA criteria to the analysis of membership in a monetary union should not be overemphasized
• the degree of symmetry of contemporaneous shocks is only one aspect of the costs associated with membership in a monetary union
• there might be other costs of EMU accession of at least the same importance as the dissimilarity of shocks
• the still existing substantial asymmetries in terms of shocks, among the present EMU countries, suggest that this is probably not the most important criterion.

Summary originally provided by GDNet, an Eldis content partner

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