Should the Euro area be run as a closed economy?

Carlo Favero, Francesco Giavazzi, 21 January 2008

The European Economic and Monetary Union (EMU) has created a new economic area, larger and closer with respect to the rest of the world. Area-specific shocks are more important than country-specific, thus it is not surprising the European Central Bank (ECB) use models to study optimal monetary policy in the Euro area assuming it works essentially as a closed economy, hit primarily by domestic shocks. The authors of CEPR DP6654 explore the variable most directly related to current and expected monetary policy, the yield on long-term government bonds, and determine whether the response of long-term rates is consistent with a closed economy.

The findings show that the level of long-term rates in Europe is almost entirely explained by U.S. shocks and by the systematic response of U.S. and European inflation, short-term rates and output gap to these shocks. U.S. variables seem to be more important than local variables in the policy rule followed by European monetary authorities. Therefore, using closed economy models to analyze monetary policy in the Euro area is inconsistent with the empirical evidence on the determinants of long-term rates and with the way the Governing Council of the ECB appears to make actual policy decisions.

The fact that European long-term rates respond more to financial shocks than they do to monetary policy instances when the ECB deviates from its rule points to the importance of incorporating into the analysis of Euro area monetary policy the effects of fluctuations in international asset prices. They suggest that the ability of the ECB to affect macro fluctuations could be limited. Asset prices fluctuations and their international comovements are currently absent from the models employed by the ECB, so extending them should be a priority of the bank’s staff.

DP6654 Should the Euro Area be Run as a Closed Economy?

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URL: http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=6654.asp
Topics: EU institutions, Monetary policy
Tags: DSGE models, ECB, monetary policy, yield curve

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