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Business Cycles Synchronisations in the Eurozone: A Dynamic Factor Model Approach

Zhang He

Before the establishment of the eurozone, it was criticised as a non-optimal single currency according to the Optimal Currency Area theory, such that the occurrence of 'one size fits all' monetary policy issue would be potentially problematic in the single currency area. However, there were also theories suggesting that the intra-trade and economic integration among members can improve the co-movements of cycles; therefore, different countries will be more likely be subject to common patterns of economic shocks. This would indicate that the appropriateness of the ECB's single monetary policy could be improved after the granting of eurozone membership. Consequently, this paper investigates the outcome of these competing forces through examining the synchronisation of business cycles in the Eurozone. By adopting the Dynamic Factor Model (DFM), we are able to investigate the synchronisation of individual business cycles against the EMU common trend by considering the data from members' nation level aggregates, whereby the common trend of the eurozone cycles is captured by the unobservable common factor for all observations. This method enable us to employ the time series data for consideration of each member's growth dynamic, but without falling into the problem of low degrees of freedom which is a common issue for the research of eurozone macroeconomics. The results suggest an imbalance of business cycle synchronisation between eurozone members, particularly for those countries which were badly suffered during the current eurozone crisis (i.e. Greece, Ireland and Portugal). Hence, it this study tentatively suggests that it would appear optimal for a number of countries to exit the eurozone.

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