Monetary Transmission Mechanism: Empirical Evidence from Eurozone

Abstract

This paper examines the effectiveness and extent of monetary transmission mechanism from Federal Funds Rate (FFR) to London Interbank Offered Rate (LIBOR). The paper employs a co-integration technique, Granger causality test, and vector Error Correction (VEC) model to examine the direction of causality and the extent and size of the pass-through effect from FFR to LIBOR. The study considers two sub-periods: the first period spans 1994:02-2008:12, and the second period covers 2009:01-2019:01, recognized as a period of implementing unconventional monetary policy to find out if there is any difference between the size of the pass-through effect during the conventional and unconventional monetary policy. Finally, the study uses a structural VAR model to measure the impact of a shock to FFR on the Eurozone economic growth. The estimated results indicate a significant co-integration relationship between FFR and LIBOR for both sub-periods and the causality runs from FFR to LIBOR in both periods. However, the pass through effect is statistically stronger in the second sub-period during unconventional monetary policy. In addition, the results suggest that a shock to FFR has a significant impact on the level of economic growth in Eurozone. This result has important policy implications for monetary authorities in the Eurozone as they can offset the effects of a shock to FFR by using the appropriate monetary policy.