Globalization and Synchronization of Business Cycles

• Author: M. Ayhan Kose
• Pages: 1-3

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Understanding changes in the degree of synchronization of business cycles is of considerable interest from a policy perspective in a number of respects. With stronger business cycle transmission, policy measures taken by one country could have a larger impact on economic activity in other countries, implying that the degree of synchronization of business cycle fluctuations has important implications for international policy coordination (Obstfeld and Rogoff, 2002).

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If global factors play a dominant role in explaining business cycles, domestic policies targeting external balances to stabilize macroeconomic fluctuations might have a limited impact. The extent of business cycle synchronization among a group of countries is also an important criterion in determining whether a currency union among those countries is desirable and feasible.

Economic theory does not provide a definitive conclusion regarding the impact of globalization on the synchronization of business cycles (Brooks and others, 2003). Increased trade in goods would normally be expected to heighten both demand-and supply-side spillovers across countries. However, Kose and Yi (2001) show that higher trade intensity leads to lower business cycle correlations in standard international business cycle models because favorable shocks to a country's productivity lead capital and other resources to move to that country. If industry-specific shocks are important in driving business cycles, increased intra-industry specialization across countries can increase cyclical comovement, but the degree of comovement might fall if inter-industry trade linkages are spurred.

Recent empirical research finds that stronger trade linkages have a positive impact on cross-country output correlations. For example, based on cross-country or cross-region panel regressions, Frankel and Rose (1998), Clark and van Wincoop (2001), Kose and Yi (2002), and Imbs (2004a, 2004b) show that, among advanced countries, pairs of countries that trade more with each other exhibit a higher degree of business cycle comovement.

The theoretical effect of increased financial flows on cross-country output correlations depends on the nature of shocks and specialization patterns. For instance, stronger financial linkages could generate higher cross-country synchronization of output by allowing easier spillovers of demand-side shocks. However, financial linkages could stimulate specialization of production through the reallocation of capital in a manner consistent with countries' comparative advantage. This type of specialization, which could result in more vulnerability to industry-or country-specific shocks, could lead to a decrease in the degree of output correlations while inducing stronger comovement of consumption across countries (Kalemli-Ozcan, Sorensen, and Yosha, 2003).

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