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

  • di Giovanni, Julian

    ()

    (International Monetary Fund)

  • McCrary, Justin

    ()

    (University of California, Berkeley)

  • Wachter, Till von

    ()

    (University of California, Los Angeles)

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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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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  1. Obstfeld, Maurice & Shambaugh, Jay C. & Taylor, Alan M., 2004. "The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility," Center for International and Development Economics Research, Working Paper Series qt4rq9v2rb, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
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  8. Christina D. Romer & David H. Romer, 1989. "Does Monetary Policy Matter? A New Test in the Spirit of Friedman and Schwartz," NBER Working Papers 2966, National Bureau of Economic Research, Inc.
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  11. Bernanke, Ben S & Blinder, Alan S, 1992. "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review, American Economic Association, vol. 82(4), pages 901-21, September.
  12. Frankel, Jeffrey A & Rose, Andrew K, 1998. "The Endogeneity of the Optimum Currency Area Criteria," Economic Journal, Royal Economic Society, vol. 108(449), pages 1009-25, July.
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