Should the Euro Area Be Run as a Closed Economy?
AbstractThe 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 built by the staff of the European Central Bank (ECB) to study optimal monetary policy in the Euro area (for instance Smets and Wouters, 2004a, 2004b) typically assume that this works essentially as a closed economy, hit by domestic shocks - 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. Two-country models exist at the ECB (e.g. de Walque, Smets, Wouters, 2005) but they overlook asset price fluctuations and their international comovements. This paper studies monetary policy in the Euro area looking at the variable most directly related to current and expected monetary policy, the yield on long term government bonds. We explore how the behaviour of European long-term rates has been affected by EMU and whether the response of long-term rates to monetary policy has got any closer to that consistent with a closed economy. We find that the level of long-term rates in Europe is almost entirely explained by U.S. shocks and by the systematic response of U.S. and European variables (inflation, short term rates and the output gap) to these shocks. Our results suggest in particular that U.S. variables are more important than local variables in the policy rule followed by European monetary authorities: this was true for the Bundesbank before EMU and has remained true for the ECB, at least so far. Using closed economy models to analyze monetary policy in the Euro is thus inconsistent with the empirical evidence on the determinants of Euro area long-term rates. It is also inconsistent with the way the Governing Council of the ECB a
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Bibliographic InfoArticle provided by American Economic Association in its journal American Economic Review.
Volume (Year): 98 (2008)
Issue (Month): 2 (May)
Other versions of this item:
- Carlo Favero & Francesco Giavazzi, 2008. "Should the Euro Area be Run as a Closed Economy?," Working Papers 331, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
- Favero, Carlo A & Giavazzi, Francesco, 2008. "Should the Euro Area be Run as a Closed Economy?," CEPR Discussion Papers 6654, C.E.P.R. Discussion Papers.
- F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
- F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
- E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
- F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission
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