Bilateral business cycle synchronisation in the EMU: What is the role of fiscal policy and government size?

This paper investigates the effects of fiscal policy and public-sector size on the bilateral business cycle synchronisation between 14 EU countries, while controlling for the effects of factor productivity, trade, inflation, sectoral specialisation and trade intensity. A time-varying framework is employed to measure bilateral business cycle synchronisation in the first instance, and a panel approach is used to establish the role of fiscal variables in determining these bilateral synchronisations. The findings suggest similarities in the size of the public sector, as well as, divergence in fiscal policy matter for the determination of business cycle synchronisation. Hence, increased fiscal federalism in EMU will contribute to increased business cycle synchronisation. In addition, we show that trade intensity, inflation differentials and differences in capital productivity also matter for the level synchronisation. These results remain robust to different specification and sub-periods.