Ebook Convergence of pass-through from money market to lending rates in EMU countries: New evidence
On January 1st, 1999 Europe entered a new era with the adoption of a single currency - the euro - by 11 of the European Union’s 15 member states. For the first time since the Roman Empire, a large portion of Europe again shares a common currency. The launch of the euro has created the world’s second largest single currency area in terms of economic size after the Unites States (Eijffinger and De Haan, 2000).
With the start of the Economic and Monetary Union (EMU), participating countries no longer have their own monetary policy. The European Central Bank (ECB) is responsible for monetary policy decisions in the euro zone. The move toward EMU has been accompanied by extensive discussions about asymmetries in monetary transmission across the euro zone countries. Most of the evidence is based on Vector Auto Regressions (VARs). The conclusions of the various studies differ markedly. Whereas, for instance, Barran et al. (1996) only find small differences, Rawasmamy and Sloek (1997) and Ehrmann (2000) report substantial differences in the impact of monetary policy measures across countries in the euro area.
Amongst other things, the impact of monetary policy on the real economy depends on how changes in policy rates are transmitted to market interest rates. Two elements are crucial for the transmission of monetary policy decisions: the speed and the degree to which changes in the policy rate affect the cost of borrowing. A well-known study by Cottarelli and Kourelis (1994) on the pass through of monetary policy measures concludes that the degree of stickiness of market rates is, on average, quite high and shows considerable variation, especially in the short run, also in the countries in the euro area.
The purpose of this paper is to examine how the pass through of monetary policy measures in the six largest EMU countries (Belgium, Germany, Spain, France, Italy, and The Netherlands) has evolved over time. The countries in our sample cover most of the euro zone. We want to answer the question whether or not the pass through has become more similar in these countries, i.e. whether there is convergence in monetary transmission. This is an important issue. Some of the critics of EMU have argued that asymmetries in monetary transmission across the countries in the euro area may seriously hamper the common monetary policy of the ECB (see e.g. Dornbusch et al., 1998).
Most previous studies have focused on differences in pass through across countries at a certain point in time. In contrast, we focus on the question of whether differences in pass through across countries, if any, have increased or decreased over time. Our estimation period is 1980-2000. For our purpose, we first estimate the long-run relationship between money market and lending rates using the FM-OLS estimator and test for parameter instability following Hansen (1992). As these tests indicate that certain changes have occurred over time, we then apply an Error Correction Model (ECM) with a moving window in which the number of observations remains the same. For each regression one observation at the beginning of the window is dropped and one is added at the end of the window.
We conclude that differences in pass through exist in our sample, both in terms of initial as well as long-run responses to policy-induced interest rate changes. However, there is some (weak) evidence for convergence of monetary policy transmission.
The remainder of the paper is organized as follows. Section 2 offers a brief review of the literature. Section 3 presents our model and the data used, while section 4 contains our estimation results. The final section offers some concluding comments.
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