The European Economic and Monetary Union (EMU) has created a new economic area, larger and closer with respect to the rest of the world. Area-specific shocks are thus more important in EMU than country-specific shocks used to be in the previous states, e.g. in Germany. It is thus not surprising that the models used to determine optimal monetary policy in the Euro area (for instance Smets and Wouters, 2004, ) assume that this works essentially as a closed economy, hit by domestic shocks, ---i.e. the same assumption made in standard models of U.S. monetary policy (see e.g. Christiano et al., 1999 ),where all shocks are domestic with the only possible exception of energy price shocks. This paper looks at the financial variable most directly related to current and expected monetary policy, the yield on long term government bonds, to explore how the behaviour of European long-term rates has been affected by the euro change-over and if the response of long-term rates to monetary policy has got any closer to that consistent with a closed economy from 1999 onwards. We conclude that running monetary policy in the Euro area as if it were a closed economy is not consistent with the empirical evidence on the determinants of Euro area long-term rates. We find that the level of long-term rates in Europe is almost total explained by U.S. shocks and the systematic response of US and European variables to these shocks. We also find that unpredictable fluctuations in long-term rates are not determined by monetary policy but rather on term premia. Systematic monetary policy in Europe is much more important in the determination of long-term rates than monetary policy shocks, and systematic monetary policy in Europe keeps responding to US variables before and after the Euro.

Should the euro area be run as a closed economy?

FAVERO, CARLO AMBROGIO;GIAVAZZI, FRANCESCO
2008

Abstract

The European Economic and Monetary Union (EMU) has created a new economic area, larger and closer with respect to the rest of the world. Area-specific shocks are thus more important in EMU than country-specific shocks used to be in the previous states, e.g. in Germany. It is thus not surprising that the models used to determine optimal monetary policy in the Euro area (for instance Smets and Wouters, 2004, ) assume that this works essentially as a closed economy, hit by domestic shocks, ---i.e. the same assumption made in standard models of U.S. monetary policy (see e.g. Christiano et al., 1999 ),where all shocks are domestic with the only possible exception of energy price shocks. This paper looks at the financial variable most directly related to current and expected monetary policy, the yield on long term government bonds, to explore how the behaviour of European long-term rates has been affected by the euro change-over and if the response of long-term rates to monetary policy has got any closer to that consistent with a closed economy from 1999 onwards. We conclude that running monetary policy in the Euro area as if it were a closed economy is not consistent with the empirical evidence on the determinants of Euro area long-term rates. We find that the level of long-term rates in Europe is almost total explained by U.S. shocks and the systematic response of US and European variables to these shocks. We also find that unpredictable fluctuations in long-term rates are not determined by monetary policy but rather on term premia. Systematic monetary policy in Europe is much more important in the determination of long-term rates than monetary policy shocks, and systematic monetary policy in Europe keeps responding to US variables before and after the Euro.
2008
Favero, CARLO AMBROGIO; Giavazzi, Francesco
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Utilizza questo identificativo per citare o creare un link a questo documento: https://hdl.handle.net/11565/202591
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