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Should the Euro Area Be Run as a Closed Economy?

  • Carlo Favero
  • Francesco Giavazzi

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 find that the level of longterm 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 appears to make actual policy decisions.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.2.138
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 98 (2008)
Issue (Month): 2 (May)
Pages: 138-45

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Handle: RePEc:aea:aecrev:v:98:y:2008:i:2:p:138-45
Note: DOI: 10.1257/aer.98.2.138
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  1. Dées, Stéphane & Vansteenkiste, Isabel, 2007. "The transmission of US cyclical developments to the rest of the world," Working Paper Series 0798, European Central Bank.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1997. "Monetary policy shocks: what have we learned and to what end?," Working Paper Series, Macroeconomic Issues WP-97-18, Federal Reserve Bank of Chicago.
  3. Evans, Charles L. & Marshall, David A., 1998. "Monetary policy and the term structure of nominal interest rates: Evidence and theory," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 49(1), pages 53-111, December.
  4. Roush, Jennifer E., 2007. "The expectations theory works for monetary policy shocks," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1631-1643, September.
  5. Wendy Edelberg & David Marshall, 1996. "Monetary policy shocks and long-term interest rates," Economic Perspectives, Federal Reserve Bank of Chicago, issue Mar, pages 2-17.
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