DP10828 Country shocks, monetary policy expectations and ECB decisions. A dynamic non-linear approach
Previous studies have shown that the effectiveness of monetary policy depends, to a large extent, on the market expectations of its future actions. This paper proposes an econometric framework to address the effect of the current state of the economy on monetary policy expectations. Specifically, we study the effect of contractionary (or expansionary) demand (or supply) shocks hitting the euro area countries on the expectations of the ECB?s monetary policy in two stages. In the first stage, we construct indexes of real activity and inflation dynamics for each country, based on soft and hard indicators. In the second stage, we use those indexes to provide assessments on the type of aggregate shock hitting each country and assess its effect on monetary policy expectations at different horizons. Our results indicate that expectations are responsive to aggregate contractionary shocks, but not to expansionary shocks. Particularly, contractionary demand shocks have a negative effect on short term monetary policy expectations, while contractionary supply shocks have negative effect on medium and long term expectations. Moreover, shocks to different economies do not have significantly different effects on expectations, although some differences across countries arise.