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Following Germany's Lead: Using International Monetary Linkages to Identify the Effect of Monetary Policy on the Economy

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Author Info

  • di Giovanni, Julian

    ()
    (International Monetary Fund)

  • McCrary, Justin

    ()
    (University of California, Berkeley)

  • Wachter, Till von

    ()
    (Columbia University)

Abstract

Forward-looking behavior on the part of the monetary authority leads least squares estimates to understate the true growth consequences of monetary policy interventions. We present instrumental variables estimates of the impact of interest rates on real output growth for several European countries, using German interest rates as the instrument. We compare this identification strategy to the vector autoregression approach, and give an interpretation of our estimates that is appropriate in a dynamic context. Moreover, we show that the difference between least squares and instrumental variables estimates provides bounds for the degree of endogeneity in monetary policy. The results confirm a considerable downward bias of estimates that do not account for potential forward-looking monetary policy decisions. The bias is higher for countries whose monetary policy was more independent of Germany.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 1495.

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Length: 46 pages
Date of creation: Feb 2005
Date of revision:
Publication status: published in: Review of Economics and Statistics, 2009, 91 (2), 315 - 331
Handle: RePEc:iza:izadps:dp1495

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Keywords: forward looking bias; instrumental variables; monetary policy;

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Cited by:
  1. Arend, Mario, 2005. "Efectos de una nueva medida de shock monetario bajo el esquema de metas de inflación en Chile
    [Effects of a New Measure of Monetary Shock Under Inflation Targeting in Chile]
    ," MPRA Paper 27156, University Library of Munich, Germany.

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