The Effects of Monetary Policy in the Euro Area: First Results from the Flow of Funds

Abstract

This paper provides new evidence on the transmission of monetary policy in the euro area, assessing the effects of a monetary tightening on the lending and borrowing activities of households, firms and other economic sectors. I exploit, for the first time, the information content of the flow-of-funds statistics, representing the most complete framework for analysing the flows of funds moving from one sector (the lender) to the other (the borrower). I estimate a parsimonious recursive VAR in order to identify monetary policy shocks in the euro area. Its predictions as to the responses of the main economic aggregates are in line both with existing literature and with theoretical priors on the effects a monetary policy shock should produce, without suffering from the empirical puzzles that can be found in some previous works. The benchmark model is then extended to include the flow-of-funds variables. I find evidence of a certain degree of inertia in firms’ behaviour. In fact, following a policy tightening firms increase net funds raised at impact. Households adjust their financial investment and borrowing attitude quite rapidly after the shock, reducing the overall accumulation of financial assets and switching from deposits and mutual fund shares to short-term securities. Special attention is devoted to the impact of a policy tightening on loans to the private sector. As in previous studies on the euro-area economy, we find that an interest-rate hike is followed by an increase in loans granted to households and firms in the short run. This result, which anyway is not as counter-intuitive as it may look, vanishes when only bank loans are taken into account in the analysis.