Differences in the Transmission of Monetary Policy in the Euro-Area: An Empirical Approach

This paper examines the impact of interest rate changes on real economic activity for a range of European Union (EU) countries including Ireland. The objective is to compare how monetary policy changes are transmitted to output in these economies. The analysis is based on evidence prior to the establishment of the common monetary policy within Economic and Monetary Union (EMU). A number of international studies over the last five years, in particular by the International Monetary Fund (IMF) and the Bank of International Settlements (BIS), have analysed how the effects of monetary policy can vary between countries. These studies have analysed most EU countries but Ireland has generally been omitted. This is due in part to the lack of the necessary quarterly national accounts’ data for output but also to the small weighting of Irish output in the euro area. This paper re-addresses the omission of Ireland by using a constructed quarterly GDP data series from 1972 to 1998. The paper, in line with previous international studies, applies a common methodology based on time series relationships and economic theory that incorporates three variables - prices, output and interest rates. This common methodology is applied to thirteen EU countries. In order to compare the responses similar data series, sample periods and an identical econometric framework are used for all countries. The transmission mechanism is the process through which monetary policy decisions are transmitted into changes in output. Economic theory tends to draw a distinction between the short and medium term when distinguishing the effects of monetary policy on the real economy. Over the medium term inflation is primarily a monetary phenomenon and in terms of the real effects on output, money is considered to be neutral. In the short term, however, monetary policy is considered to have real effects. There are two important dimensions to the conduct of monetary policy to be clearly distinguished. The first is the adjustment of monetary policy instruments in reaction to changes in objective variables such as output and inflation. The second is the impact of monetary authorities’ actions on the real economy. The paper concentrates on the latter. The monetary transmission mechanism consists of several inter-linked channels, such as the interest rate or money channel, the credit channel, the exchange rate channel and the asset price channel, which can differ substantially across countries. The focus of this paper is on the aggregate effect of these different transmission channels rather than on the relative importance of each in the different EU countries. The motivation for this focus arises from the need for the real effects of monetary policy to be relatively uniform across the different EU countries in order to facilitate the smooth conduct of monetary policy in the euro-area. It is also motivated by the lack of consensus on the effects of monetary policy changes through different channels in different countries or even within a given country. The lack of consensus stems from the difficulty in disentangling time series on interest rates into parts that are due to deliberate monetary policy measures and those that are due to endogenous responses of financial markets to unobserved economic disturbances. As a result, different empirical methodologies give rise to different estimates of the role and effect of monetary policy. The results from the common specification used by the international agencies would suggest that a monetary shock resulting in higher interest rates would seem to have an implausibly large and persistent impact on output in the Irish case in comparison to other EU countries. This may point to the need for a unique econometric specification for each economy in order to capture the differences in the monetary transmission mechanism more accurately rather than something unique about the Irish economy. The consequence of this recommendation would diminish the comparability of the results, but to proceed otherwise would be ill advised. Using a modified framework shows that the effects on output from interest rate changes in the smaller, peripheral countries in the EU, such as Ireland, Portugal, Finland and Denmark are deeper than those in the larger countries. While the magnitude of effects may be similar in these groups, the duration over which they occur can differ markedly. Therefore no consistent, common grouping emerges in terms of impact and duration. There is no evidence on the basis of this paper that there is a core group of countries, with the exclusion of Ireland, forming an obvious optimum currency area with the EU.