The European dimension: Consequences for European monetary policy

[Introduction] The Eurozone creates a number of new challenges in policy-making in Europe. These challenges exist both for the monetary and the fiscal authorities. In this workpackage we aim at providing novel insights in the nature of these challenges using new approaches in modelling the macro economy. These new approaches highlight the importance of multiple equilibria, herd behaviour and animal spirits (market sentiments). The first challenge is for the monetary authorities to understand the nature of the transmission of monetary policies. We analyse this transmission process using a behavioural macroeconomic model in which animal spirits play a major role. We contrast this transmission process in a bank based with a market based financial model. As the Eurozone is mainly based on bank finance the comparison with a market based financial model will allow us to identify what is special in the monetary transmission process in the Eurozone. The second challenge has to do with crisis management. During financial crises panic and fear is likely to take over, creating a potential for self-fulfilling liquidity crises. These can push countries into a bad equilibrium that forces them into imposing excessive austerity thereby reinforcing deflationary dynamics. We provide evidence that these forces have been at work during the sovereign debt crisis of 2010-12. The third challenge relates to the governance of the Eurozone. It is clear that the Eurozone has not yet achieved a governance structure that will guarantee its long run survival. In a third contribution we use empirical evidence about the nature of economic shocks in the Eurozone to analyse how the Eurozone should be redesigned so as to become sustainable in the long run.