The majority of OECD countries has experienced a reduction in macroeconomic volatility during the last two decades. This period is also characterized by a gradual liberalization of the capital accounts in these countries. We first show that, on average, countries/periods with more open capital markets are associated with lower macroeconomic volatility. Second we provide a theory of why capital account liberalization can lead to less macroeconomic volatility. In a simple open economy setting we study the impact of more open capital markets on the transmission and the amplification of two types of shocks: financial and real. We find that, in any given country, greater international integration substantially reduces the amplification of financial shocks; we also find that this channel can quantitatively affect business cycles dynamics. Our findings suggest that up to 1/3 of the worldwide reduction in business cycle volatility can be explained by greater international financial integration.
