The Effect of Exchange Rate Regimes on Business Cycle Synchronization: A Robust Analysis

In contrast to the widely recognized importance of exchange rate regimes, evidence on their effect on business cycle synchronization focuses almost exclusively on the role of currency unions, thus implicitly ignoring potential effect of other exchange rate regimes. In this paper we use a new dataset on bilateral de-facto exchange rate regimes for the period 1973-2016 to study the effect of seven types of regimes on business cycle synchronization. Using the Extreme Bound Analysis (EBA) methodology, we find that the exchange rate regime is a robust determinant of business cycle synchronization. Compared to country pairs with freely floating arrangements, we find that: (i) the correlation coefficient measuring business cycle synchronization is higher by around 0.12 points in countries with no separate legal tenders; (ii) other hard pegs such as currency board arrangements and de-facto pegs have also significantly more synchronised business cycles, but the size of the correlation coefficient is halved compared to countries with no separate legal tenders; (iii) the effect is not always linearly decreasing with the increasing exchange rate regime flexibility, since crawling pegs and crawling bands turn out to be insignificant, whereas the effect of moving bands as a more flexible type of exchange rate regimes is positive and significant; (iv) the effect is stronger for countries with high degree of financial openness and good institutional quality.