Trade and business cycle co-movement: evidence from the EU

Abstract

This paper studies empirically the determinants of business cycle co-movement using a panel of European countries (1972-2004). We find that both policy convergence (in particular fiscal policy) and bilateral trade intensity are robust determinants of real co-movement in Europe, this confirming the seminal study by Frankel and Rose (1998), and more recent finding by Bergman (2004) and Darvas, Rose and Svapary (2005). Moreover ,once controlling for policy convergence, the effect of bilateral trade on business cycle co-movement weakens by a factor of 36%-33%. This finding is interpreted as being evidence in favour of the recent claim by Gruben, Koo and Millis (2002) that Frankel and Rose econometric procedure suffers from omitted variables bias and endogeneity in the set of instruments.