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Should the Euro Area Be Run as a Closed Economy?

Author

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  • Carlo Favero
  • Francesco Giavazzi

Abstract

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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Suggested Citation

  • Carlo Favero & Francesco Giavazzi, 2008. "Should the Euro Area Be Run as a Closed Economy?," American Economic Review, American Economic Association, vol. 98(2), pages 138-145, May.
  • 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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    References listed on IDEAS

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    1. Roush, Jennifer E., 2007. "The expectations theory works for monetary policy shocks," Journal of Monetary Economics, Elsevier, vol. 54(6), pages 1631-1643, September.
    2. Christiano, Lawrence J. & Eichenbaum, Martin & Evans, Charles L., 1999. "Monetary policy shocks: What have we learned and to what end?," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 2, pages 65-148 Elsevier.
    3. Vansteenkiste, Isabel & Dées, Stéphane, 2007. "The transmission of US cyclical developments to the rest of the world," Working Paper Series 798, European Central Bank.
    4. 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.
    5. Wendy Edelberg & David A. 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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    Citations

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    Cited by:

    1. Libo Yin & Liyan Han, 2014. "Spillovers of macroeconomic uncertainty among major economies," Applied Economics Letters, Taylor & Francis Journals, vol. 21(13), pages 938-944, September.
    2. Cornand, Camille & Gandré, Pauline & Gimet, Céline, 2016. "Increase in home bias in the Eurozone debt crisis: The role of domestic shocks," Economic Modelling, Elsevier, vol. 53(C), pages 445-469.
    3. Helge Berger & Thomas Harjes, 2009. "Does Global Liquidity Matter for Monetary Policy in the Euro Area?," International Finance, Wiley Blackwell, vol. 12(1), pages 33-55, May.
    4. Hugo ROJAS-ROMAGOSA & Luis RIVERA, "undated". "Human Capital Formation and the Linkage between Trade and Poverty: The Cases of Costa Rica and Nicaragua," EcoMod2010 259600142, EcoMod.
    5. Netšunajev, Aleksei & Glass, Katharina, 2017. "Uncertainty and employment dynamics in the euro area and the US," Journal of Macroeconomics, Elsevier, vol. 51(C), pages 48-62.
    6. Giovanna BUA, 2016. "International Risk Taking Channel in Emerging Markets," Departmental Working Papers 2016-01, Department of Economics, Management and Quantitative Methods at Università degli Studi di Milano.
    7. Colombo, Valentina, 2013. "Economic policy uncertainty in the US: Does it matter for the Euro area?," Economics Letters, Elsevier, vol. 121(1), pages 39-42.
    8. Ansgar Belke & Thomas Osowski, 2017. "International Effects of Euro Area versus US Policy Uncertainty: A FAVAR Approach," ROME Working Papers 201703, ROME Network.
    9. repec:eee:eecrev:v:100:y:2017:i:c:p:95-115 is not listed on IDEAS
    10. Mili, Mehdi & Sahut, Jean-Michel & Teulon, Frédéric, 2012. "Non linear and asymmetric linkages between real growth in the Euro area and global financial market conditions: New evidence," Economic Modelling, Elsevier, vol. 29(3), pages 734-741.
    11. Palladini, Giorgia & Portes, Richard, 2011. "Sovereign CDS and Bond Pricing Dynamics in the Euro-area," CEPR Discussion Papers 8651, C.E.P.R. Discussion Papers.
    12. Syed Hassan & Sarosh Shabi & Taufiq Choudhry, 2018. "US Economic Uncertainty, EU Business Cycles and the Global Financial Crisis," Working Papers 2018-05, Swansea University, School of Management.
    13. Md Rafayet Alam, 2015. "Economic policy uncertainty in the US: Does it matter for Canada?," Economics Bulletin, AccessEcon, vol. 35(4), pages 2725-2732.
    14. Carvalho, Daniel & Fidora, Michael, 2015. "Capital inflows and euro area long-term interest rates," Journal of International Money and Finance, Elsevier, vol. 54(C), pages 186-204.
    15. D'Adamo, Gaetano, 2010. "Estimating Central Bank preferences in a small open economy: Sweden 1995-2009," MPRA Paper 26575, University Library of Munich, Germany.
    16. Marco Lombardi & Raphael A Espinoza & Fabio Fornari, 2009. "The Role of Financial Variables in Predicting Economic Activity in the Euro Area," IMF Working Papers 09/241, International Monetary Fund.

    More about this item

    JEL classification:

    • 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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