DP1632 National Policies and Local Economies: Europe and the United States

Author(s): Mario Forni , Lucrezia Reichlin

Publication Date: April 1997

Keyword(s): Business Cycle , Dynamic Factor Model , European Integration

JEL(s): C51 , E32 , O30

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP1632.asp

This paper studies the synchronization of output fluctuations in European regions and US counties. We extend the two component dynamic factor model à la Sargent and Sims (1977) by introducing an intermediate-level shock, which is common to all regions (counties) in each country (state), but it is not common to Europe (United States) as a whole. We build on Forni and Reichlin (1995, 1996) to propose a simple method of estimation which is based on Law of Large Numbers results and exploits the large cross-sectional dimension of the data set. The empirical findings show that Europe has a level of integration similar to that of the United States. In general, we find that the national dimension in Europe is not very important: around 75% of output variance is explained by global and purely local dynamics. Similar numbers are found for US counties and US states. The study of the dynamic profile of the components, however, shows that Europe, unlike the United States, has no traditional business cycle. Shocks are very persistent and the bulk of the variance is in the long run. We also find a European core of regions with a particularly high level of integration. The core is not defined by a set of nations, however, but by regions belonging to different countries.