The advent of European Economic and Monetary Union (EMU) scheduled for the beginning of 1999 has sparked off a debate about the best way of conducting monetary policy in the euro area. One dimension of this discussion concerns the preferred framework for conducting monetary policy-that is, about whether the European Central Bank (ECB) ought to target inflation, monetary aggregates, or the exchange rate. A second is about differences in the effects of changes in monetary policy on activity in different EU countries, related to differences in the transmission mechanism.
Opinions have tended to be divided on the question of the preferred monetary policy framework for the euro area, although recently, there appears to be a consensus emerging in favor of informal inflation targeting, accompanied by monitoring of monetary aggregates and other indicators. In any event, policy discussions have in general tended to focus less on questions relating to the real effects of monetary policy in the EU than on the issue of the appropriate framework for conducting monetary policy in the euro area. This may be partly due to the fact that many of the issues pertaining to identification of the monetary transmission mechanism tend to be econometric rather than economic. Nevertheless, a proper understanding of possible differences in the effects of changes in monetary policy on activity among the EU countries is crucial for an appreciation of the difficulties that may arise from the implementation of a unified monetary policy throughout the euro area. And this issue is the main focus of the paper.
Recent empirical studies of the effects of monetary policy on activity have focused mainly on a subset of EU countries. Gerlach and Smets (1995), using a vector autoregression (VAR) approach with long-run identifying restrictions, found that the effects of a change in the monetary stance on output were somewhat larger in Germany than in France or Italy, while the United Kingdom fell somewhere in between. However, the differences in the transmission of monetary policy documented in the Gerlach-Smets study were not found to be very large. Barran, Coudert, and Mojon (1996) estimate a VAR using the recursive Choleski identifying assumptions to document the differences in the transmission of monetary policy for a group of EU countries. They find that the effect of a contractionary monetary shock on output is relatively long lasting in Germany, with output (relative to baseline) bottoming out about 10 quarters after the shock, somewhat less long lasting in the United Kingdom with output bottoming out after about 8 quarters, whilst in France output reaches the trough about 6 quarters after the shock. A recent Bank of England study by Britton and Whitley (1997), which simulates a variant of the Mundell-Flemming model to analyze the transmission mechanism, found that the response of output to an interest rate shock was smaller in the United Kingdom than in Germany or France, but that the differences in the transmission of monetary policy among these countries were not very large. Dornbusch, Favero, and Giavazzi (1998) estimate the impact of a coordinated monetary policy move on activity in a group of EU countries, controlling for intra-European exchange rates. They find that the “impact-effects” of a change in monetary policy are similar in Germany, France, and the United Kingdom, but smaller than in Sweden and Italy. The full effects of the coordinated monetary policy move are, however, lower in the United Kingdom than in Germany and France, a result that is broadly consistent with that of Britton and Whitley (1997).
An interesting finding that emerges from these studies, which use different estimation strategies, is that there are differences in the effects of monetary policy on activity among the large EU countries. However, these differences do not correspond closely to popular perceptions about how output may be expected to respond to changes in monetary policy. In particular, some of these studies indicate that the response of output to monetary policy actions is not more sensitive in the United Kingdom than it is in some “core” EU countries.
This paper analyzes the nature of the differences in the effects of monetary policy on activity in the EU by examining a larger set of EU countries than previous studies. Moreover, unlike previous empirical studies, which have each relied on one particular model specification for estimating the dynamics of the transmission of monetary policy, this paper examines the robustness of the estimates of the response of output to monetary shocks in the different EU countries with respect to alternative specifications of the VAR approach. The main finding is that, based on estimates using the VAR approach, the EU countries fall into two broad groups as far as the transmission of monetary policy is concerned. In one group (Austria, Belgium, Finland, Germany, the Netherlands, and the United Kingdom) output (relative to baseline) typically bottoms out about 11 to 12 quarters following a contractionary monetary shock, with the decline in output being in the range of 0.7 to 0.9 percent from the baseline. In the other group (Denmark, France, Italy, Portugal, Spain, and Sweden), output typically bottoms out about 5 to 6 quarters after a contractionary monetary shock, with the decline in output being in the range of 0.4 to 0.6 percent from baseline. It is interesting to note in this context that while these two groups of EU countries bear a relatively close resemblance to the “core” and the “periphery,” respectively, that are distinguished in the literature on asymmetric shocks, there are some important differences. The response of activity to monetary shocks in Finland and the United Kingdom corresponds more closely to that of the “EU core,” whereas the real effects of monetary policy in France appear to correspond more closely to that of the “EU periphery.” It is, of course, important to note that these results are derived on the basis of past relationships between monetary shocks and activity in the EU countries. EMU will constitute a regime shift that could well lead to shifts in behavioral relationships
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