The Transmission of Monetary Policy via Common Cycles in the Euro Area

TL;DR

This paper investigates how common economic cycles in the euro area influence the transmission of monetary policy, revealing that while common cycles drive most variations, country-specific factors cause heterogeneous responses, especially post-financial crisis.

Contribution

It introduces a FAVAR model with proxy variables and sign restrictions to analyze the role of common cycles in monetary policy transmission within the euro area.

Findings

Common cycles explain most variation in output and inflation across countries.

Southern European economies diverged from common cycles after the financial crisis.

Heterogeneous country responses are driven by country-specific financial market exposures.

Abstract

We use a FAVAR model with proxy variables and sign restrictions to investigate the role of the euro area's common output and inflation cycles in the transmission of monetary policy shocks. Our findings indicate that common cycles explain most of the variation in output and inflation across member countries. However, Southern European economies exhibit a notable divergence from these cycles in the aftermath of the financial crisis. Building on this evidence, we demonstrate that monetary policy is homogeneously propagated to member countries via the common cycles. In contrast, country-specific transmission channels lead to heterogeneous country responses to monetary policy shocks. Consequently, our empirical results suggest that the divergent effects of ECB monetary policy are attributable to heterogeneous country-specific exposures to financial markets, rather than to dis-synchronized economies within the euro area.