Financial integration within Europe and the international transmission of business cycles among industrialized countries

Abstract

We exploit a dataset on financial integration within Europe to answer a novel question in the international Real Business Cycle (RBC) literature. Does financial integration within Europe matter for the international transmission of business cycles between the United States and Europe? We find that it does, and that as European countries become more financially integrated among themselves, European business cycles start to ‘decouple’ from those in the United States. We show that this is true for three macro indicators of economic activity: Gross Domestic Product (GDP), consumption and investment, and for five alternative measures of the degree of financial integration. We also show that the effect of trade linkages becomes insignificant once financial factors are accounted for. Our work has interesting policy implications since it unveils the importance of further integration in the EU to slow down the transmission of aggregate shocks among industrialized nations.