How similar are country- and sector-responses to common shocks within the euro area?

Abstract

Ever since the introduction of the Euro, there have been discussions about whether Europe constitutes an optimal currency area. The Great Recession and the European debt crisis have rekindled and intensified this debate. Heterogeneous country experiences have led to questioning the rationale for a common monetary policy in the absence of a common fiscal framework to cushion macroeconomic shocks. In this paper, we examine whether the impact of typical macroeconomic shocks at the European Monetary Union (EMU) level varies across countries and sectors. We follow Furlanetto et al. (2017) and estimate common euro area macroeconomic supply, demand, monetary, investment, and financial shocks using sign restrictions. We calculate the impulse responses to these shocks at the country-sector level using local linear projections and propose a measure for business cycle synchronisation based on the similarity of the responses. We find varying degrees of heterogeneity across member countries' responses to common EMU shocks. Although the responses of economic sectors are themselves heterogeneous, different sector-decompositions across countries cannot explain the cross-country heterogeneity. Contrary to e.g. Bayoumi and Eichengreen (1993, 2017), we identify Italy to be a core country. In line with recent literature, the level of heterogeneity was the most pronounced during the financial crisis compared to pre- and post-crisis periods.