Capital mobility and the synchronization of business cycles: Evidence from the European Union

Abstract

Business cycle synchronization (BCS) is crucial for effective common monetary policy in the Eurozone. However, the impact of capital market integration on BCS is ambiguous in the literature. In this paper, we quantify the different channels through which capital mobility affects BCS, considering dynamic panel framework accounting for model uncertainty, reverse causality, and contagion. Four different channels are examined: exuberance of business cycles through short-run flows, risk-sharing-induced specialization, international value chain integration resulting from foreign direct investment, and contagion. The results show that the overall impact of capital mobility on BCS is positive in the EU.