Business Cycle Synchronization and Vertical Trade Integration: A Case Study of the Eurozone and East Asia

Abstract

Business cycle synchronization is one of the crucial conditions for a currency union to be successful. Frankel and Rose (1998) argued that increased trade after euro adoption would increase business cycle synchronization ex-ante. However, the fallout of the Eurozone forcefully demonstrated that their optimistic prediction did not turn out to be true. One thing Frankel and Rose (1998) did not examine is how different types of trade (inter vs. intra, vertical vs. horizontal, etc.) intensify/dampens business cycle synchronization. In this light, this paper empirically examines how different types of trade affect business cycle synchronization in what way. This study takes two major economic blocs that have been going under rapid economic integrations: The original Eurozone members and East Asia – integration of former mainly developing by European government initiative and the latter naturally forming by the global supply chain and associated product segmentation. Comparing these two very different economic blocs with very different factor endowment structures would give us a more convincing answer to how different types of trade can influence business cycle synchronization differently. Our key finding is that, on the contrary to Frankel and Rose (1998) , the impact of increased trade intensity on business cycle co-movement is ambiguous. The impact of trade on business cycle synchronization depends on types of trade. Intra-industry trade, especially vertical intra-industry trade which is rapidly growing in East Asia, has a strong positive effect on business cycle synchronization while inter-industry trade does not.