Monetary policy in the euro area – has it become more powerful on the road to EMU?

Abstract

This article provides new evidence on the effects of monetary policy in the euro area. With the help of a time-varying coefficient vector autoregressive model we find that monetary policy shocks have had a greater impact on real output since the mid-1980s and that their transmission has become faster. Our findings indicate a change in the monetary transmission mechanism that can be explained by the changes in the European financial system over the last 20 years.

Notes

¹ The type of coefficient variation that is allowed for is essential the modeling of structural breaks and potential non-linearities. Simulation results from Neumann (2003) suggest that random walk coefficients dominate many other commonly used approaches to time-varying estimation.

² The EM algorithm is applied to find the maximum likelihood estimates of the hyperparameters to initialize the Kalman filter.

³ Computing error bands for the time-varying impulse responses remains an unresolved issue.

Fig. 1. Accumulated impulse responses of GDP to a monetary policy shock in the euro area: (a) Response over time after 4 quarters; (b) Response over time after 8 quarters; (c) Response over time after 12 quarters; (d) Response over time after 16 quartersNote: Y-axis gives percentage impact on output to a one-unit shock (1% increase in the short-term interest rate).