Trade Integration and Business Cycle Synchronization in the EMU: the Negative Effect of New Trade Flows

This paper questions the impact of trade integration on business cycle synchronization in the EMU by distinguishing increase of existing trade flows (the intensive margin) and creation of new trade flows (the extensive margin). Using a DSGE model, we find that synchronization is weakened when new firms are allowed to export in response to productivity gains. Using disaggregated data over 1995–2007 for the 10 founding members of the EMU and consistently with our model, we find that trade intensity has a positive direct effect while new trade flows have a negative effect on business cycle synchronization. Furthermore, new flows play essentially an indirect role by intensifying specialization and explain 60% of the overall effect of trade intensity and specialization on synchronization.