Academic journal article Baltic Journal of Economics

Convergence between the Business Cycles of Central and Eastern European Countries and the Euro Area

Academic journal article Baltic Journal of Economics

Convergence between the Business Cycles of Central and Eastern European Countries and the Euro Area

Article excerpt

Abstract

Although entry to the Euro area (EA) is based only on fulfilment of the Maastricht criteria, implementation of optimum currency criteria and real economic convergence determines the benefits and costs of monetary integration. This paper focuses on the synchronization of business cycles among Central and Eastern European countries (CEECs) and the EA. Business cycles are extracted from GDP data series using a double Hodrick-Prescott filter method. The degree of co-movement of cycles is evaluated on the basis of various methods of rolling correlation. Results show that there is no common CEE business cycle, although a synchronization trend is evident. Similarly, there is a strong trend of convergence of CEEC national business cycles toward that of the EA.

Keywords: Business cycles, Central and Eastern European countries, Monetary integration, Euro area

JEL classification: F33, F44

1. Introduction

While EU officials emphasize respect for the Maastricht criteria for entry to European monetary union, researchers have focused on the criteria of an optimal currency area (OCA). OCA theory states that countries are more suited to belonging to a monetary union when they meet certain criteria related to real economic convergence: a high degree of external openness, mobility of factors of production, and diversification of production structures. A strong degree of business-cycle synchronization across monetary union members reduces the cost of giving up an independent exchange rate and monetary policy, especially when alternative adjustment mechanisms are unable to absorb the impact of (temporary) asymmetrical shocks across countries because of price and wage rigidities and insufficient labour mobility.

Business-cycle synchronization in currency unions is very significant from a policy perspective. In the context of a single currency and common monetary policies in the Euro area, the resemblance of the business cycles of participant countries is a major concern (Koopman and Azevedo, 2008). If synchronization of business cycles in the union is high, the critique that a common monetary policy may not be equally good for all countries or regions in the union ("one size does not fit all") can be dismissed. However, if the business cycles of member countries are desynchronized, a common monetary policy may have a different effect in the various economies. This could raise tensions among member states and endanger the union. Business-cycle synchronization results from common external shocks and similar transmission of country-specific shocks through various macroeconomic channels such as international trade in goods and financial assets. Although international trade in goods is usually thought of as fostering business-cycle synchronization, its overall effects remain theoretically ambiguous. On the demand side, higher aggregate demand in one country will partially fall on imported goods, thereby raising the output and income of trading partners and inducing output co-movements across countries (Walti, 2011). On the supply side, however, there are two opposing effects. According to the "optimistic view", economic and monetary integration will stimulate intra-industrial trade relations, which in turn will lead to better business-cycle synchronization (Jeffrey A. Frankel and Andrew Κ. Rose, 1997, 1998).

On the other hand, trade integration may lead economies to specialize in production of goods for which they have a comparative advantage, hence reducing co-movements. Furthermore, Paul R. Krugman (2003) argues that integration could lead to regional concentration of industrial activities, mainly because of economies of scale and scope. Because of this concentration, sector-specific shocks may become region-specific shocks, thereby increasing the likelihood of asymmetric shocks and diverging business cycles.

Regardless previous considerations, Ayhan Kose, Christopher Otrok, and Eswar Prasad (2012) conclude that the increase in trade and financial linkages among industrial countries and among EMEs [emerging market economies] has been associated with the emergence of group-specific cycles. …

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