Discussion Paper Details

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Title: Uncertainty shocks in currency unions

Author(s): Benjamin Born, Gernot Müller and Johannes Pfeifer

Publication Date: December 2020

Keyword(s): Euro Area, Euro crisis, Exchange Rate Regime, monetary policy and Uncertainty shocks

Programme Area(s): International Macroeconomics and Finance and Monetary Economics and Fluctuations

Abstract: Uncertainty shocks cause economic activity to contract and more so, if monetary policy is constrained by an effective lower bound on interest rates. In this paper, we investigate whether countries within currency unions are also particularly prone to suffer from the adverse effects of heightened uncertainty because they lack monetary independence. First, we estimate a Bayesian VAR on quarterly time series for Spain. We find that country-specific uncertainty shocks impact economic activity adversely. Second, we calibrate a DSGE model of a small open economy and show that it is able to account for the evidence. Finally, we show that currency-union membership strongly reduces the effects of uncertainty shocks because it anchors long-run expectations of the price level and thus alleviates precautionary price setting in the face of increased uncertainty.

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Bibliographic Reference

Born, B, Müller, G and Pfeifer, J. 2020. 'Uncertainty shocks in currency unions'. London, Centre for Economic Policy Research.