Should the Euro Area be Run as a Closed Economy?

Carlo Favero and Francesco Giavazzi ()

No 331, Working Papers from IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University

Abstract: 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 find that the level of longterm rates in Europe is almost entirely explained by U.S. shocks and by the systematic response of U.S. and European variables (inflation, short term rates and the output gap) to these shocks. Our results suggest in particular that U.S. variables are more important than local variables in the policy rule followed by European monetary authorities: this was true for the Bundesbank before EMU and has remained true for the ECB, at least so far. Using closed economy models to analyze monetary policy in the Euro is thus inconsistent with the empirical evidence on the determinants of Euro area long-term rates. It is also inconsistent with the way the Governing Council of the ECB appears to make actual policy decisions.

Date: 2008
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Journal Article: Should the Euro Area Be Run as a Closed Economy? (2008)
Working Paper: Should the Euro Area be Run as a Closed Economy? (2008)
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