Should the Euro Area be Run as a Closed Economy?

Abstract

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-specifi cs hocks are thus more important in EMU than country-specific shocks used to be in the previous states, e.g. in Germany. It is thus not surprising that the models used to determine optimal monetary policy in the Euro area (for instance Smets and Wouters, 2004, ) assume that this works essentially as a closed economy, hit by domestic shocks– i.e. the same assumption made in standard models of U.S. monetary policy (see e.g. Christiano et al., 1999 ), where all shocks are domestic with the only possible exception of energy price shocks. This paper studies monetary policy in the Euro area looking at the variable most directly related to current and expected monetary policy, the yield on long term government bonds. We explore how the behaviour of European long-term rates has been affected by EMU and whether the response of long-term rates to monetary policy has got any closer to that consistent with a closed economy. We find 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 variables to these shocks. The systematic component of European monetary policy responds to U.S. variables more than it does to local variables. This was true for the Bundesbank before EMU and remains true for the ECB since the start of EMU. We also find that unpredictable fluctuations in long-term rates are driven by shocks to term premia,.not to monetary policy. This means that the ECB can affect long rates only through the systematic component of its monetary policy–which, as we have seen, mostly responds to U.S. variables. Monetary policy ”shocks” induced by the ECB have virtually no effect on long rates. Claiming that monetary policy in the Euro area can be determined as if the region were a closed economy is thus not consistent with the empirical evidence on