Comparing monetary policy reaction functions: ECB versus Bundesbank

Abstract

This paper compares the European Central Bank’s (ECB) conduct of monetary policy with that of the Bundesbank. Estimated monetary policy reaction functions show that the ECB reacts similarly to expected inflation but significantly stronger to the output gap than the Bundesbank did. Theoretical considerations suggest that this stronger response to the output gap may rather be due to a higher interest rate sensitivity of the German output gap than to a higher weight given to output stabilisation in the objective function of the ECB. Counterfactual simulations based on the estimated interest rate reaction functions reveal that German interest rates would not have been lower under a hypothetical Bundesbank regime after 1999. However, this conclusion crucially depends on the assumption of an unchanged long-run real interest rate for the EMU period and is reversed when the Bundesbank reaction function is adjusted for the lower long-run real interest rate estimated for the ECB regime.