Introduction

Central banks are usually assigned two main goals: the most recent one, which has become their priority objective over the last three decades, is price stability; the second one, which is historically their raison d’être, is to ensure the integrity of payments. In modern economies, this takes the form of the smooth functioning of interbank exchanges on the money market, which contributes to and depends on the maintenance of financial stability.

In accordance with economic theory, central banks have assigned specific instruments to each of these two objectives. The short-term interest rate has emerged, over the last three decades, as the main instrument with which monetary policy pursues its price stability objective. Central banks support the functioning of the money market through a continuum of instruments, ranging from their marginal standing facilities to the granting of liquidity assistance to troubled money-issuing institutions or lender of last resort (LOLR) to the financial system as a whole. These operations can, however, be sterilised in order to insulate the stance of monetary policy. Looking back at the first twelve years of the euro, this separation in the pursuit of the two objectives, which is consistent with the Tinbergen principle, has not been challenged until recently when short-term nominal interest rates reached their (zero) lower bound in 2009. The Eurosystem then, along with many other central banks throughout the world, embarked on non-conventional policies. The circumstances of the financial crisis and the great recession blurred the separation between the means mobilised by the euro area central bank in the pursuit of its two objectives.

Introduction

There is a long tradition of describing the main regularities in the economic fluctuations by reporting the standard deviations and cross-correlations of de-trended macroeconomic time series. Economists, originally mostly contributors to the Real Business Cycle (RBC) research programme, have then used these cyclical properties as benchmarks to discriminate across competing theoretical models. Against this background, the cyclical properties of the US economy (Stock and Watson, 1999) and other OECD countries (Baxter, 1995) are well documented. On the contrary, no study has yet described systematically the cyclical properties of the euro area.

This chapter fills this gap by compiling the moments of de-trended euro area macroeconomic time series. For comparison, we also report similar statistics for the USA and for euro area countries.

We find that the cyclical properties of the euro area and the USA are surprisingly similar in mainly three respects: the magnitude of the fluctuations in consumption, investment, prices, inflation, interest rate and monetary aggregates relative to the fluctuations of GDP; the patterns of cross-correlation of GDP components, prices and interest rates with respect to GDP; and the persistence of GDP and of prices.

We also describe the high synchronicity of national cycles and the euro area aggregate cycle. This synchronicity is observed for the main GDP components as well as for the short-term interest rate. It is particularly high for the largest countries of the euro area and for Austria, Belgium and the Netherlands, which belonged to the core ERM.

In 1999 the European Central Bank (ECB), together with the National Central Banks (NCBs) of the countries that had just adopted the euro, launched a major research initiative to study the transmission of monetary policy. The objective was to put together, in a reasonably short time, a comprehensive body of information on how the monetary policy of the newly created central bank would affect the economy of the ‘euro area’. In December 2001 this research was presented to academics and central bankers in an international conference at the ECB. This book brings together, in revised and shortened form, all the contributions presented at that conference. It also includes a summary of the discussion and some further papers that, owing to time constraints, could not be presented then. For the reader, this book provides an overview of the project results and access to the most comprehensive set of analyses on the working of the single European monetary policy yet published.

Knowledge of the transmission mechanism is needed to determine how the monetary policy instruments should be set to achieve the desired goals. Interest rate decisions by central banks always rely on some explicit or implicit understanding of the transmission mechanism. Moreover, ideally this understanding suggests also how to efficiently achieve the monetary policy goal, i.e. limiting undesired side effects on other economic variables besides the ones the central bank is directly responsible for. Finally, understanding the transmission mechanism is critical for the external communication of policy.

This book presents to the community of central bankers and academics, and to the public at large, the results of the research project undertaken by the Eurosystem Monetary Transmission Network (MTN) on the transmission of monetary policy in the euro area. This is the first comprehensive research project completed jointly by the European Central Bank (ECB) and by the euro area National Central Banks (NCBs) after the introduction, in 1999, of the new single European currency, the euro.

The choice of monetary policy transmission as the topic for this study was a logical and almost a necessary one. The transmission process is a central issue for every central banker. It figures prominently in the preparation, decision-making and communication of monetary policy. Good analysis is needed to get information on the transmission mechanism and to make it systematic and soundly based on economic theory and data evidence. This task was assigned, shortly after the onset of the single European monetary policy, to the Monetary Transmission Network, a team of Eurosystem economists with the proper mix of expertise. Their work lasted some two years. Preliminary results of this research were presented, even before its completion, to a number of academic and policy-making audiences on both sides of the Atlantic. Disseminating in-house research, particularly when the topic is of such policy relevance, is an integral part of central bank communication. This book is part of this communication effort.

The macroeconomic evidence in Part 1 suggests that an important part of the output adjustments that are induced by monetary policy are ultimately due to changes in investment. The chapters in this section of book use firm level data to better understand the investment dynamics. A survey paper by J. B. Chatelain, A. Generale, I. Hernando, P. Vermeulen and U. von Kalckreuth is followed by country specific analyses focused on Belgium, Germany, France, Italy, Luxembourg and Austria.

The motivation for using firm-level data is two fold. First, using micro data may make it possible to side step some of the problems associated with studies that rely on aggregate data. Specifically, the simultaneity problem that plagues macroeconomic studies of investment is of particular concern for inferences regarding monetary transmission. Since short term interest rates tend to move counter-cyclically, there will be a natural tendency for interest rate changes to appear to have limited effects on investment. It is extremely difficult to find any econometric instruments that could be used to solve this problem.

The studies in this project largely identify the link between investment and the user cost of capital off of cross-firm variation in the user cost, much which of which is due to tax differences and other sources of asymmetry in firm-specific interest rates. These differences give rise to exogenous cross-firm variation that can be exploited in the estimation. Moreover, other firm-level instruments are often available for the endogenous components of the user cost.

The chapters in part 2 have shown that liquidity factors are likely to play a role in the investment decisions of firms in a number of euro area countries, in addition to interest rates and the cost of capital. This suggests that financial conditions may matter in the transmission of monetary policy. Banks, which occupy a central position in the euro area's financial system, are a natural focus of attention here. The chapters that follow contain a summary of evidence of the impact of monetary policy on the lending behaviour of banks. An opening summary chapter by M. Ehrmann, L. Gambacorta, J. Martínez-Pagés, P. Sevestre and A. Worms (chapter 14), brings together the evidence for the euro area, followed by more specific studies on Germany, Spain, France, Greece, Italy, the Netherlands, Austria, Portugal and Finland.

The vast international literature on the role of banks in monetary policy transmission in recent years has yielded a number of conclusions. First, there seems to be conclusive evidence that changes in policy-driven interest rates are followed by significant adjustments in bank balance sheets. Bank lending normally tends to contract after a montary policy restriction. Likewise, the most liquid components of bank liabilities (such as checking and demand deposits) also tend to fall with some lag. The effect on total deposits is more uncertain, as some redistribution takes place towards longer-term deposits.