Monetary policy in the euro area has long been challenged by financial, economic, and institutional heterogeneity among member countries (Cœuré 2019). While financial markets arguably experienced strong convergence over the first years of the euro’s existence, convergence has slowed down markedly since the financial crisis (ECB 2017). Convergence has been more modest in some other markets. Most notably, institutional characteristics of labour and housing markets show large differences across the currency block. These circumstances have raised two long-standing questions for policymakers and academics alike. First, to which extent is the transmission of the ECB’s monetary policy heterogeneous across the euro area? Second, how do differences in institutional characteristics of specific markets weigh on the observed heterogeneity? The COVID-19 crisis has made finding answers to these questions all the more urgent, in view of the large asymmetries in exposure of euro area member countries to the pandemic and its economic effects.
In a recent working paper (Corsetti et al. 2020), we take a novel approach, integrating empirical and quantitative analysis. First, we derive a statistical measure of the dispersion in the country-specific responses to a common monetary shock by calculating the coefficient of variation in the impulse responses obtained from a state-of-the-art factor model. Second, we build a small ‘dynamic stochastic general equilibrium’ (DSGE) model of a currency union, enriched with a housing market and calibrated to Spain, and assess the extent to which European housing parameters can explain differences in the transmission of monetary policy.
How does the ECB’s monetary policy transmit to member countries?
Our main empirical results concerning the transmission of monetary policy in the euro area are synthesised in Figure 1, which plots the country-specific responses to a common monetary shock for different variables of interest. To obtain these responses, we use a rich factor model and identify common monetary policy shocks by constructing an external instrument based on changes in the one-year Euro Overnight Index Average (EONIA) swap rate (i.e. the Overnight Index Swap (OIS) rate for the euro area) around policy announcements. This instrument has been proven to be economically meaningful, in that it highlights the implications of using various means of policy communication (including press releases, press statements, and Q&A sessions) for the transmission of current and expected future policy (Altavilla et al. 2019, Jarociński and Karadi 2019). As a broad measure of monetary policy surprises, our instrument series incorporates all of the communication channels mentioned above.
Figure 1 Percentage responses of selected variables to a 25bp contractionary policy shock across euro area member countries.
Note: each step represents one quarter.
The figure highlights that the degree of heterogeneity varies across variables. Financial variables (stock prices and long-term interest rates) react fairly similarly across euro area member states. On the contrary, consumer price inflation (HICP), consumption, unemployment, and (especially) housing prices react in significantly asymmetric ways. This is actually a general pattern: we find more dispersion and heterogeneity in the responses of variables related to housing and labour markets, than for financial variables. We take these results as evidence that the degree of heterogeneity in the transmission of monetary policy is inversely related to the degree of cross-border institutional convergence of markets.
The question remains as to how to measure (and statistically test) heterogeneity in the responses of economic variables to a common shock. Existing research has looked at this issue from different angles. Most recently, for instance, Slacalek et al. (2020) focus on the impact of monetary policy shocks on consumption in a subset of euro area countries. Formulating a back-of-the-envelope approach, the authors study and quantify different transmission mechanisms.
We propose an approach that integrates empirics and theory further. For each set of impulse responses that we obtain from our empirical model (e.g. GDP across member countries), we calculate the coefficient of variation, a statistic also known as ‘relative standard deviation’. In practice, we calculate the coefficient of variation for a variable as the standard deviation of responses across countries, normalised by the size of the average response. This gives us a statistical measure of the heterogeneity that allows for an intuitive and meaningful comparison across variables.
Returning to the results shown in figure 1, the dispersion in the responses of output and national financial variables is low (between 20% to 50% of the average response). For the other variables (related to markets that have experienced little convergence), we find that the dispersion in the country-specific responses is twice as large as the average response.
The importance of housing financing in explaining the observed heterogeneity: a case study
With our measure of the heterogeneity of transmission at hand, we turn to a quantitative assessment. Our question of interest is how much of the variation in individual euro area countries’ responses to a monetary policy shock can be explained by structural differences in markets. We focus on differences in housing markets (specifically, market characteristics for housing financing) as a case study.
We build a model for a small open economy with housing (operating in a monetary union) and calibrate the baseline to Spain. Using this benchmark calibration, we vary the loan-to-value ratios and shares of adjustable-rate mortgage contracts to mimic observed data for different countries. This procedure allows us to compare the dispersion of the simulated impulse response functions with the dispersion we estimated in the empirical section of the paper. To be clear: we do not recalibrate the model for each country in our sample, hence our quantitative responses cannot account for the many economic factors other than housing financing that may help to match the evidence. However, holding all parameters other than loan-to-value ratios and the share of adjustable-rate mortgages constant allows us to isolate more clearly the specific role played by housing financing in monetary transmission.
The results from our exercise are remarkable: we find that national differences in mortgage market characteristics alone can explain up to a third of the cross-country heterogeneity of responses in output and private consumption across euro area countries.
Implications for monetary policy
The COVID-19 crisis may threaten (and undo) some of the progress in market integration in the euro area. Notably, each member state has adopted a different mix of housing and mortgage policies (e.g. regarding forbearance and mortgage contract redesign) which can potentially compound the institutional differences in housing markets. In light of our findings, these differences may exacerbate the heterogeneity in the impact of monetary policy, thus creating further challenges to conducting monetary policy in the euro area.
Authors’ note: The views expressed in this column are those of the authors and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
Altavilla, C, L Brugnolini, R S Gürkaynak, R Motto and G Ragusa (2019), “Measuring euro area monetary policy”, Journal of Monetary Economics 108: 162-179.
Cœuré, B (2019), Speech Banque de France Symposium & 34th SUERF Colloquium on the occasion of the 20th anniversary of the euro on ‘The Euro Area: Staying the Course through Uncertainties’, Paris.
Corsetti, G, J Duarte and S Mann (2020), “One Money, Many Markets: Monetary Transmission and Housing Financing in the Euro Area”, CEPR Discussion Papers (No. 14968).
ECB (2017), “Financial integration in Europe”, Annual Report.
Jarociński, M and P Karadi (2020), "Deconstructing Monetary Policy Surprises—The Role of Information Shocks", American Economic Journal: Macroeconomics 12 (2): 1-43.
Slacalek, J, O Tristani and G L Violante (2020), “Household balance sheet channels of monetary policy: A back of the envelope calculation for the Euro Area”, Journal of Economic Dynamics and Control.