Comparing monetary policy reaction functions: ECB versus Bundesbank

This paper compares the European Central Bank’s (ECB) conduct of monetary policy with that of the Bundesbank. Estimated monetary policy reaction functions show that the ECB reacts similarly to expected inflation but significantly stronger to the output gap than the Bundesbank did. Theoretical considerations suggest that this stronger response to the output gap may rather be due to a higher interest rate sensitivity of the German output gap than to a higher weight given to output stabilisation in the objective function of the ECB. Counterfactual simulations based on the estimated interest rate reaction functions reveal that German interest rates would not have been lower under a hypothetical Bundesbank regime after 1999. However, this conclusion crucially depends on the assumption of an unchanged long-run real interest rate for the EMU period and is reversed when the Bundesbank reaction function is adjusted for the lower long-run real interest rate estimated for the ECB regime.

Interest linkages between the US,UK and German interest rates: should the UK join the European Monetary Union?

In light of continuing mixed results in the literature, this paper re‐examines the German Dominance Hypothesis (GDH) and considers whether the UK should join the Eurozone. For this purpose, short‐term interest rate relationships between the UK, Germany, the Eurozone and the USA, for the period January 1982 to June 2007, are studied. The policy implication of a loss of monetary autonomy for the UK in favour of Germany or the European Central Bank (ECB) would give support to the UK joining the EMU as an economic response. From the early 1980s the Bundesbank’s responsibility was to use money growth targets to keep average inflation rate down in the long run. This long run objective suggests that an appropriate methodology for testing the GDH is to test whether the German stochastic trend is a driving stochastic trend. In other words we determine whether a permanent shock to the German interest rate has a permanent effect on the UK interest rate. To this end the structural shocks in a VECM are identified by imposing long‐run restrictions of the type developed in King et al. (1991). We apply the same techniques to testing whether the UK has suffered a loss of monetary autonomy in favour of the ECB.     

How Will EMU Affect Inflation and Unemployment in Europe?

This paper explores how European Monetary Union will change the wage setting behavior of national labor unions. We derive the impact of national inflation aversion and labor militancy on the performance of national labor markets under different monetary arrangements. A common central bank raises inflation and unemployment if it acts as conservatively as national central banks. However, unemployment falls in countries that previously tied their monetary policy to the Bundesbank. We also examine the composition of EMU and the influence of national labor market legislation.
JEL Classification : E 24; F 02; F 33     

Games of monetary and fiscal interactions in the EMU

This paper constructs various models of the EMU and ECB when member countries have different objectives. Voting in pursuit of national interest can yield moderate and stable inflation. The metaphor of Walsh-type contracts implements a monetary policy rule that averages the member countries’ most preferred rules. In a repeated relationship where a country suffering a large adverse shock can use political bargaining to subvert the ECB's commitment, the optimal rule should incorporate some flexibility to forestall that. Finally, freedom of national fiscal policies undermines the ECB's monetary commitment; this may justify fiscal constraints like the Stability and Growth Pact.     

Lessons from the ECB Experience: Frankfurt Still Matters!

This paper compares the European Central Bank's (ECB) conduct of monetary policy (1999–2005) with that of the Bundesbank (after the German Unification: 1990–1998) in order to test the hypothesis of an ECB with 'Bundesbank's preferences' put forward in the theoretical literature ( Alesina and Grilli, 1993 ; Fatum, 2006 ). Econometric tests and simulations based on monetary policy reaction functions show that the continuation of the former Bundesbank regime is supported by the data. Given this empirical evidence we discuss the lessons for future Monetary Unions stemming from the ECB experience.     

Monetary and Fiscal Policy Interactions in the Euro Area

The problem of monetary and fiscal policy interactions is an important issue for the euro area, since the individual member states of the EMU are responsible for their fiscal policies but monetary policy is pursued by a single monetary authority, the ECB. This paper is concerned with empirical evidence on monetary and fiscal policy interactions in the euro area. We first explore fiscal regimes with a VAR model and find empirical evidence that a non-Ricardian fiscal policy has been pursued in both France and Germany. As an example, we then study how one member state of the EMU, namely, Italy, is responding to the common monetary policy with its fiscal policy and find that Italian fiscal policy seemed to be counteractive to the common monetary policy between 1979 and 1998. In order to study monetary and fiscal policy interactions in a more general way, we explore time-varying interactions by estimating a State-Space model with Markov-switching for some Euro-area countries. There appear to be some regime changes in monetary and fiscal policy interactions in France and Germany, but the interactions between the two policies are not strong. Moreover, the two policies have not been accommodative but counteractive to each other. Finally we explore forward-looking behavior in policy interactions and find that expectations do not seem to have played an important role in the policy designs.     

Bashing and supporting central banks: the Bundesbank and the European Central Bank

In this paper, we analyse the influences leading to external pressure on or public support for German and European monetary policy. Based upon the findings for the Deutsche Bundesbank, lessons are drawn for the European Central Bank (ECB). We show that external pressure on the ECB stems mainly from politicians or from international organisations (such as the IMF). In contrast with evidence for the Bundesbank, interest groups (such as commercial banks) hardly attempt to influence European monetary policy. German data show that factors leading to external pressure on the central bank are rising unemployment and the threat that governments will lose their majority in the next election. Evidence for the latter is, however, weak, and we show that in any case this source of pressure is likely to be of minor importance for the ECB.     

Estimating A European Demand For Money

European Monetary Union will come into existence in 1999. This raises questions related to the monetary policy targets that will be adopted by the European Central Bank (ECB). For both likely candidates, targeting a money aggregate or an inflation target, the existence of a stable money demand function at a European level is important. In this paper estimates of such a European money demand for narrow and broad money for the actual 11 EMU countries based on quarterly aggregate data from 1964 to 1994 are presented. It is argued that statistically satisfactory and economically interpretable functions can be found. Moreover, the estimated models appear to be stable over a period of 20 quarters. This raises the hopes that the ECB will face a stable money demand and be able—at least for a certain time—to use past aggregate data for policy purposes.     

Inflation persistence in the Euro area before and after the European Monetary Union

This paper provides new evidence on inflation persistence before and after the European Monetary Union (EMU). Taking into account fractional integration of inflation, we confirm that inflation dynamics differed considerably across Euro area countries before the start of EMU. Since 1999, however, results obtained from panel estimation indicate that the degree of long run inflation persistence has converged. In line with theoretical predictions, we find that the persistence of inflation has significantly decreased in the Euro area, probably as a result of the more effective monetary policy of the ECB.     

Deficit sustainability and inflation in EMU: An analysis from the Fiscal Theory of the Price Level

Price determination theory typically focuses on the role of monetary policy, while the role of fiscal policy is usually neglected. From a different point of view, the Fiscal Theory of the Price Level takes into account monetary and fiscal policy interactions and assumes that fiscal policy may determine the price level, even if monetary authorities pursue an inflation targeting strategy. In this paper we try to test empirically whether the time path of the government budget in EMU countries would have affected price level determination. Our results point to the sustainability of fiscal policy in all the EMU countries but Finland, although no firm conclusions can be drawn about the prevalence of either monetary or fiscal dominance.     

Pattern Bargaining and Wage Leadership in a Small Open Economy*

Pattern bargaining with the tradables (manufacturing) sector as the wage leader is common in Europe. We question the conventional wisdom that such bargaining produces wage restraint. In our model, all forms of pattern bargaining give the same outcomes as uncoordinated bargaining under inflation targeting. Under a monetary union, wage leadership for the non‐tradables sector is conducive to wage restraint, whereas wage leadership for the tradables sector is not. Comparison thinking might lead the follower to set the same wage as the leader. Such equilibria can arise when the leader sector is the smaller sector, and these can promote high employment.     

Controlling inflation in Euroland

The experience with the two pillar strategy of the European Central Bank (ECB) suggests that at some point in the future the ECB may have to commit to one of the more traditional policy strategies – a direct inflation target or an intermediate monetary target. This study offers some information on the scale of control and indicator problems associated with both strategies. We estimate the links between monetary policy actions and inflation in dynamic linear models with the Kalman filter. Using European M3 that the ECB has published, it is found that the overall control problems involved in targeting money are larger than for direct inflation targets.     

A simple inflation indicator for the euro zone

This article proposes and estimates an inflation indicator for the European Monetary Union (EMU). This indicator is set up so that it is contemporarily not affected by the changes in price differentials among EMU countries. The results show that the Monetary Union Index of Consumer Prices (MUICP), which is the inflation measure that the European Central Bank (ECB) takes as a reference for monetary policy purposes, could be understating the value of the inflation in the euro zone. It is also concluded that regional peculiarities are fundamental in the evolution of prices in the different EMU countries.     

Coordination versus flexibility in wage formation: a focus on the nominal wage impact of productivity in Germany,Greece, Ireland,Portugal, Spain and the United States

Wage coordination between countries of the European Monetary Union (EMU) aims at aligning nominal wage growth with labour productivity growth at the national level. We analyse the developments in Germany, the EMU’s periphery countries Greece, Ireland, Portugal and Spain along with the United States over the period 1980 to 2010. Apart from the contribution of productivity to nominal wages, we take into account the contributions of prices, unemployment, replacement rates and taxes by means of an econometrically estimated nonlinear equation resulting from a wage bargaining model. We further study the downward rigidities of nominal wages. The findings show that in past times of low productivity, price inflation and reductions in unemployment still put significant upward pressure on nominal wage growth. The periphery countries are far from aligning nominal wage growth with productivity growth. German productivity is a major wage determinant, but surely not the only one. Within the context of a free bargaining process between employers and labour unions, policy-makers can effectively use the replacement rate to steer the nominal wages outcome.     

THE POLITICS OF MAASTRICHT

The Economic and Monetary Union (EMU) treaty signed at Maastricht does not guarantee the recreation of German-style economic policies and outcomes at the European Community (EC) level. Membership was not limited to countries that mimic the German commitment to price stability. National representatives may outvote inflation-averse EC central bankers in monetary policy decisions. The Council of Ministers has the power to set exchange rate policy vis-à-vis third currencies. The treaty does not provide binding constraints against fiscal profligacy in member states. The German government agreed to this suboptimal outcome because in the wake of the demise of the Soviet Union and German unification it had broader political interests in maintaining the pace of European integration at Maastricht. The Bundesbank's policy of high interest rates in 1992, however, has effectively guaranteed a two-speed monetary union, in which the first group of members will be limited to a narrow deutschemark zone. Given the waning enthusiasm for integration across the EC, the German government has no incentive to alter this outcome.     

Causes of Inflation in Europe, the United States and Japan: Some Lessons for Maintaining Price Stability in the EMU from a Structural VAR Approach

Price stability being among the primary goals of EMU monetary policy,it should be interesting to analyse thefactors that led to the disinflationarydevelopments of the last years. Using a structural VAR approach withlong-run identifying restrictions derived from an open-economy macromodel, various factors of inflation for Austria, Germany, Italy, the UnitedKingdom, the United States and Japan and the extent to which they havecontributed to inflation are analysed. These factors are energy price shocks, supply shocks, wage setting influences, demand and exchange rate disturbances and money supply surprises. The latter three are also used to calculate core inflation. Within a smaller model for aggregate EMU data, supply and demand influences are analysed. While supply and demand factors have generally contributed to the inflation decline, monetary policy, enhanced competition, low energy prices and moderate wage setting are featuring most prominent in the recent disinflation process.     

Wage restraint and monetary union

Existing work on wage bargaining predicts more aggressive wage setting under monetary union. This is exemplified by Cukierman and Lippi (2001) who postulate that wages are set having area-wide prices in mind. The insight of aggressive wage behaviour has not been confirmed by the EMU experience, which has been characterised by wage moderation. The present paper investigates the possibility of wage restraint using a monetary union model which, realistically, assumes that trade unions set wages with national prices in mind. Drawing on plausible ranges for all parameter values (and macroeconomic shocks), our simulations show that a monetary union elicits real wages that are broadly comparable to those obtained under monetary autonomy. The confidence bounds around these results are rather wide, in particular including scenarios of wage restraint.     

Monetary and Fiscal Policy-Makers in the European Economic and Monetary Union: Allies or Adversaries?

Optimal monetary and fiscal policies within the European Economic and Monetary Union (EMU) are determined by simulating a global model under alternative assumptions about the objective function of the European Central Bank (ECB) and about cooperation vs. non-cooperation between monetary and fiscal policy-makers and among the latter. The results show the high effectiveness of fixed rules in the presence of supply-side shocks and the usefulness of cooperative discretionary measures against demand-side shocks. More generally, cooperation among fiscal policy-makers in the EMU is nearly always superior to non-cooperative equilibrium solutions, yielding a strong case for the coordination of fiscal policies.     

Wages and Wage-Bargaining Institutions in the EMU – A Survey of the Issues

The paper distinguishes between the impact of the EMU on nominal wage flexibility and on equilibrium real wage and unemployment levels. A perceived need to increase nominal wage flexibility as a substitute for domestic monetary policy and a tendency to less real wage moderation in the EMU are likely to promote informal bargaining coordination and social pacts in the medium run. But such coordination is not likely to be sustainable in the long run, as it conflicts with other forces working in the direction of decentralization and deunionization. This could lead to more government intervention in wage setting during a transitional period. Although monetary unification will strengthen the incentives for higher-level transnational coordination of wage bargaining, such a development is improbable in view of the coordination costs involved. If transnational coordination develops, it is most likely to occur within multinational firms.     

Fiscal restrictions and monetary union: Rationales,repercussions, reforms

We offer a critique of the fiscal preconditions for participation in Stage III of EMU and the Excessive Deficit Procedure of the Maastricht Treaty. We show that the high output costs associated with meeting the fiscal preconditions in Stage II and the incompatibility of the reference values for fiscal policy with other convergence criteria make it unlikely that a mechanical interpretation of those conditions will govern admission to Stage III. Knowledge of this fact will deter governments from undertaking major fiscal adjustments in the first place. Hence, the fiscal criteria of the treaty will not function as an efficient filter for distinguishing countries that are and are not prepared to live with the fiscal consequences of EMU.In Stage III, the function of the Excessive Deficit Procedure is to buttress the European Central Bank's protection from demands for a central bank bailout in the event of a debt crisis in a participating state. We show that other aspects of EU fiscal structure, namely the retention by member states of the bulk of their own revenue-raising capacity, should suffice to restrain the demand for a central bank bailout and the pressure on the ECB to supply it. Until political union follows monetary union, leading to the centralization of fiscal functions and revenu-raising capacity in the EU itself, the Excessive Deficit Procedure will be redundant. If there remains any reason to doubt the credibility of the no-bailout rule, then the best way to buttress it is directly, by further insulating the ECB from pressure to extend a bailout.If it is felt that policy in EU member states is biased toward excessive deficits, then the appropriate place to address this problem is at the national level. A limited approach would involve steps to insure that negotiations over the budget occur in the context of a firm general constraint on the overall level of spending. A more far-reaching reform would involve the creation of National Debt Boards to offset the prevailing bias.