Financial Differences and Business Cycle Co-Movements in A Currency Area

I propose a unitary framework to interpret the links between differences in financial structures

and the monetary policy regimes on the one hand, and the correlation of business cycles on the

other. Using a two-country micro-founded model with financial frictions I predict that a greater

financial diversity should reduce cyclical correlation under a given monetary regime, and that

moving from independent monetary policies to a hard peg or a common currency should increase

it, for any given degree of financial diversity. I use the recent experience of EMU to test these

ideas, and show that my model explains reasonably well the broad patterns of business cycle

correlation observed recently among the main euro area countries.