Has the Euro changed the business cycle?

Abstract

In this paper we analyze European business cycles before and under EMU. Across the two periods we find 1) a significant fall in real exchange rate volatility, 2) significant changes in crosscountry correlations, and 3) the volatility of domestic aggregates largely unaltered. We develop and calibrate a two-country business cycle model to capture defining characteristics of the German economy and an aggregate of six European countries. The model is able to replicate many key features of the data, both prior to and under EMU. Counterfactual experiments suggest that the absence of non-fundamental exchange rate volatility under EMU goes a long way in accounting for the observed changes.

One money, one cycle? The EMU experience

“…The same line of argument applies to the 3 While it is well established in the literature that a currency union has a significantly positive impact on trade integration (Glick and Rose, 2002;Baldwin, 2006), the magnitude of this effect is highly controversial and subject to an intensive discourse in the literature particularly for the EMU case (see, for instance, Frankel, 2010). 4 In particular, based on a two-country business cycle model calibrated for the euro area, Enders et al (2013) show that cycles exhibit a higher co-movement under EMU because of stronger spill overs of national shocks to other EMU members. The model is calibrated for Germany vis-à-vis the aggregate of six euro area countries.…”

“…The model is calibrated for Germany vis-à-vis the aggregate of six euro area countries. The reason for the observation by Enders et al (2013) is that domestic shocks depreciate the real exchange rate by less under a common currency (compared to the pre-EMU period) because the nominal exchange rate channel is absent and prices are assumed to be sticky. 5 The only exception is Gonçalves et al (2009), which is discussed in detail below.…”

“…In fact, economies in a currency union might per se exhibit more synchronized cycles because of common monetary shocks under a single central bank. Furthermore, recent theoretical evidence also suggests a positive impact of EMU membership on business cycle synchronization due to stronger spill-over effects across member countries (Enders et al, 2013). 4 Also, increased labor mobility and the establishment of common risk sharing systems through various provisions and policies within EMU might have raised the co-movement of member countries' business cycles.…”

The euro exchange rate and Germany's trade surplus

“…DE TBY in the counterfactual is, for example, up to 0.6 pp lower without the positive DE supply‐side shocks, comprising labour market reforms and wage moderation. Despite the plausibility of a regime dependence of disturbances in parsimonious models, though, Enders, Jung, and Müller () find little evidence for EMU‐related overall changes in the European business cycle. In particular, the volatility of macroeconomic variables has remained largely unchanged, with the exception of strongly reduced REER volatility, attributable to the disappearance of bilateral nominal EXR shocks between EMU countries, and stronger comovement of macroeconomic time series across countries, which is a more general phenomenon, however, that is not specific to EMU.…”

How have global shocks impacted the real effective exchange rates of individual euro area countries since the euro’s creation?

“…The literature on the impact of EMU has focused largely on studying overall convergence in business cycles and prices within the euro area (e.g. Enders, Jung, and Müller (2009), Canova et al (2006), Engel and Rogers (2002), and Rogers (2007) 2 ), with such studies often …nding strong evidence of growing business cycles synchronization and price convergence in the run up to the introduction of the euro in 1999, albeit less so afterwards. There are also studies on the impact of EMU on European integration, focusing both on trade (e.g.…”