Introduction

Recent empirical and theoretical studies, mainly focused on the US economy, tend to converge on the view that contractionary monetary policy shocks lead to a temporary decrease in output and to a gradual decline in prices. These results are convincing, and therefore policy-relevant, mainly because they are derived from models that imbed a plausible description of the monetary policy decision process. Chapter 2 showed that the estimation of standard VAR models using euro area synthetic data also delivers this pattern of response of output and prices to identified monetary policy shocks. However, given that this approach is somewhat artificial when considering the euro area economy as a whole before the start of EMU, these results should be complemented with VARs where estimating central bank reaction functions is completely legitimate, i.e. country-level VAR models.

This chapter analyses the transmission mechanism of monetary policy in the ten countries that now form the euro area. We use VAR models, which, as argued in the introduction of the previous chapter, is the most widely used empirical methodology to analyse the transmission mechanism.

In Europe, the perspective of EMU led a large part of the literature to use VARs to evaluate cross-country differences in the transmission mechanism. The typical paper in this literature imposes the same identification of monetary policy shocks across countries, in spite of the differences in monetary policy regime of each country within the European Monetary System (EMS).