The Effect of Regional Factors on National Business Cycles

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This is the second of a three-part series examining the comovement of business cycles among countries. Today’s post will look at how similar characteristics among countries matter for business cycle synchronization.

Our previous blog post, based on a recent article in The Regional Economist,¹ discussed three components of a country’s business cycle:

• The global component, which captures the common movements in all countries’ business cycles
• The regional component, which captures the common movements with a country’s neighbors
• The country component, which captures the movements in the business cycle that are unique to that country

Previous research showed that the regional component explained only a small percentage of business cycle fluctuations. However, more recently, researchers found that the regional component’s influence on a country’s business cycle depends on how regions are defined.

A 2003 study found that the global and country components explained a substantial portion of the cyclical movements for most countries, while regional components explained far less.² As an example, the regional component for (pre-European Union) Europe explained only 2 percent of the variation in the three economic variables examined (output growth, consumption growth and investment growth).

However, this study defined regions by geographical proximity only. A 2012 study used regions based on country-specific factors, such as the degree of economic openness to trade, the investment share of real gross domestic product, the method of conflict resolution, the legal system, language, and composition of trade and production.³

These new regions resulted in three groups:

• One consisting of many industrialized nations, including Japan and most of Europe
• One consisting of the United Kingdom and many of its former British Commonwealth countries, such as Australia and the United States
• One consisting of South American countries, along with Mexico, Morocco, Senegal and the Philippines4

The authors of The Regional Economist article noted that, “Regions defined in this manner increase the share of output growth fluctuations attributable to the regional component, raising its importance relative to the global and country-specific components.”

When defining regions by location, the regional component explained just over 2 percent of the fluctuations in output growth. In contrast, these new regional components explained over 22 percent. The authors wrote, “This dramatic increase in the significance of the regional component indicates that the importance of the regional factor may be misrepresented when countries are sorted into purely geographic regions.”

Other factors may also be playing increasing roles in the links among countries’ business cycles. In particular, regional linkages and trade agreements have increased substantially. The authors noted, “If trade and financial flows across countries are becoming increasingly regional, the regional component may also find a rise in importance.” The final blog post in this series will examine whether economic linkages are becoming increasingly global or increasingly regional.

Notes and References

¹ The article was written by Assistant Vice President and Economist Michael Owyang, Senior Research Associate Diana Cooke, Research Fellow Christopher Otrok—all with the St. Louis Fed—and M. Ayhan Kose, director of the Development Prospects Group at the World Bank. (Otrok is also the Sam B. Cook Professor of Economics at the University of Missouri.)

¹ Kose, M.A.; Otrok, Christopher; and Whiteman, Charles H. “International Business Cycles: World, Region and Country-Specific Factors,” The American Economic Review, September 2003, Vol. 93, No. 4, pp. 1,216-39.

² Francis, Neville; Owyang, Michael T.; and Savascin, Ozge. “An Endogenously Clustered Factor Approach to International Business Cycles,” Working Paper 2012-014A, Federal Reserve Bank of St. Louis, 2012.

³ The full list of countries by these newly defined regions is available in the original Regional Economist article.

Follow the Series:

• What Matters More for Business Cycles: Global or Regional Factors?
• The Effect of Regional Factors on National Business Cycles
• Are Links between Countries’ Business Cycles Increasingly Global or Regional?

Additional Resources

• Regional Economist: Regional vs. Global: How Are Countries’ Business Cycles Moving Together These Days?
• On the Economy: What Determines How Much Countries Trade?
• On the Economy: What Drives Long-Run Economic Growth?