Economists have sought for some time to find out how the business cycle is affected by a country's exchange rate regime. Many investigations in the past focused on differences between the Bretton Woods period and the subsequent floating exchange rate regime. No consensus emerged from those studies as to the effect of the exchange rate regime on the cycle, partly because of the two-way causation problem. In Discussion Paper No . 1191, Research Fellow Michael Artis and Wenda Zhang ask whether the ERM has created since its inception a greater degree of business cycle conformity among the participating countries.

The authors first examine the contemporaneous correlation between the business cycles of the ERM countries (defined as the current membership plus Italy) and those of the US and Germany; distinguishing t he period s before and after the formation of the ERM . There is a quite striking shift in business cycle affiliation, from the US to Germany, between the two periods. This shift is specific to the ERM countries and is not shared by Japan, Canada or the UK . Changes in the lead/lag time characterizing the relationship between business cycles can be studied by obtaining the lead/lag at which the correlation between cycles is maximized. Using this approach, it turns out that the ERM-German cycle relationship is synchronous in the ERM period. In the earlier period, there is also a high degree of synchronicity evident with the US cycle. The strength of association between cycles can be measured by the size of the maximum correlation. By this measure the German-ERM association is particularly strong in the ERM period. The UK is the one European country for which no change in its strong association with the US cycle is evident; and the UK is not an ERM participant.

International Business Cycles And The ERM : Is There A European Business Cycle?
Michael Artis and Wenda Zhang

Discussion Paper No. 1191, August 1995 (IM)