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---

### Overview and purpose
- Part of a paper studying cross-border spillovers of European Central Bank (ECB) monetary policy to emerging European economies.
- Uses empirical (high-frequency event study and historical local projections) and model-based (two-country DSGE with financial frictions and segmented asset markets) approaches to assess spillovers from ECB conventional (interest rate-based) and unconventional (balance-sheet-based, focus on quantitative tightening) policies.

### Data coverage, variables, and identification
- Country coverage: sixteen emerging European economies (listed in the event-study section).
- High-frequency event study:
  - Frequency: daily.
  - Window: a twelve-week period surrounding the June 2022 ECB policy announcement (event window T_-6 to T_+6, with T_0 = June 9, 2022).
  - Variables: CDS spreads, government bond yields, bilateral exchange rates vis-à-vis the euro.
  - Identification proxy for ECB shocks: three-month Euribor futures rate.
- Historical (local projections) analysis:
  - Frequency: quarterly.
  - Sample period: 1999Q1 to 2022Q4 (quarterly dataset used for local projections spans 1999 Q1 to 2022 Q3 for impulse-response analysis).
  - Variables: real GDP, unemployment rate, bilateral nominal exchange rates against the euro, short-term policy rates, government bond yields at different maturities, and CDS spreads.
  - Shock identification: three-month Euribor one-year futures rates (Romer and Romer (2004) style); constructed monetary shock series with one-standard-deviation ECB monetary tightening shock σ = 0.26.

### Event selection and event-study design
- Core event: Governing Council meeting on June 9, 2022, chosen as unexpected and exogenous to markets.
- June 2022 policy statement highlights:
  - End net purchases under Asset Purchase Program (APP) as of July 1, 2022.
  - Continue reinvesting principal payments from PEPP “until at least the end of 2024”.
  - Left key ECB interest rates unchanged in June but announced intention to raise them by 25 basis points at the July meeting.
  - Actual July 2022 outcome: ECB raised interest rates by 50 basis points; first hike since 2011; largest since 2000.
- Event window: twelve-week window (T_-6 to T_+6), corresponding to six-week periods before and after the event; ECB policy dummy ECB_{i,t}^{event} = 0 before event and 1 after event.
- Regression specification (OLS, controls): Y_{i,t} = α + β ECB_{i,t}^{event} + δ ECB_{i,t}^{event} * Z_i + θ Q_t + I_i + ε_{i,t}, with Z_i structural country features and Q_t global risk factors (CBOE VIX, U.S. equity prices, oil price fluctuations).

### Event-study empirical findings (daily "before and after")
- Major outcomes following the June announcement:
  - Strong pressures on exchange rates and government bond yields across emerging European economies.
  - Bond yields rose amid rising policy rates and risk premia; CDS spreads increased.
  - Many currencies depreciated significantly against the euro, especially in countries with elevated foreign currency-denominated debt (noted exposures: Hungary, Poland, and Türkiye).
  - Sovereign spreads increased by up to 60 basis points (summary statistic referenced in appendix).
  - Some economies intervened in FX markets (examples: Albania, Moldova, Serbia) to stabilize excessive short-term exchange rate volatility.
- Heterogeneity by fundamentals and regimes:
  - Economies with substantial financing gaps experienced more pronounced effects.
  - Economies with higher reserves, more developed financial sectors, and more flexible exchange rate regimes saw more muted impacts.
  - Flexible regimes (examples in broader analysis: Albania, Hungary, and Poland) coped better; pegged/euroized regimes (examples: Bosnia and Herzegovina, Bulgaria, Kosovo, Montenegro) faced greater challenges.
- Robustness and limitation:
  - Results robust after controlling for unemployment, inflation, VIX, and oil prices.
  - Event study cannot disentangle conventional versus quantitative tightening effects within the June statement.

### Local projections methodology and identification
- Shock construction:
  - Regression includes twelve-month ahead forecasts of euro area GDP growth and inflation (Survey of Professional Forecasters), current and lagged GDP growth and inflation, and lags of the short-term rate; residual ε_t captures non-systematic unexpected policy component.
  - Monetary shock series cited has σ = 0.26.
- Local projections specification:
  - y_{i,t+h} = α_{i,h} + Σ_{s=0}^h γ_s ε̂_{t-s} + Σ_{s=0}^{h-1} β_{s,h} Z_{i,t-s} + Σ_{s=0}^{h-1} λ_{s,h} X_{i,t-s} + ε_{i,t+h}.
  - Endogenous variables y_{i,t+h}: real GDP, government bond yields, CDS, exchange rate.
  - Controls include US Federal Funds Rate, VIX, exchange rate regime, reserves position, domestic financial development, fiscal position; four lags of dependent variables included.
- Data and inference:
  - Quarterly data for 16 countries between 1999 Q1 and 2022 Q3 used for impulse responses.
  - Horizon examined: fifteen quarters following shocks.
  - Confidence bands: 90 percent; standard errors two-way clustered at country and quarter levels.
  - Alternative sample: some specifications exclude COVID period (2020 Q2 onwards).

### Local projections findings (quarterly)
- Real output:
  - Contractionary ECB monetary shocks produce persistent negative impacts on real output in emerging Europe.
  - Domestic output decreases with trough occurring after about 10 quarters.
  - Quantified summary: drop in real output reaches 0.5 percent after two years following an ECB monetary tightening shock (event/historical analysis summary).
- Sovereign debt markets and exchange rates:
  - Government bond yields increase by more than one-for-one with ECB tightening.
  - Sovereign spreads increase by up to 60 basis points.
  - Domestic currencies depreciate following ECB tightening.
- Heterogeneity:
  - Fixed exchange rate regimes and weak fundamentals (lower reserves, lower financial development) experience larger negative impacts.
  - Flexible exchange rate regimes and stronger fundamentals exhibit resilience: smaller overall shock size and more gradual impact.
- Source-of-shock nuance:
  - Spillovers are negative for pure monetary policy tightening shocks.
  - If tightening is driven by a more positive euro area outlook (information/news component), spillovers could be positive.

### Structural model (two-country DSGE) — calibration and scenarios
- Model features:
  - Two-country New-Keynesian open-economy DSGE with financial frictions and segmented asset markets; two household types (restricted and unrestricted) with transaction costs on long-term bond trading.
  - QE mechanism: asset purchases reduce long-term bond supply, lowering expected returns on long-term bonds and affecting consumption and output.
  - Long-UIP linkage generates exchange-rate effects from foreign long-term rate changes.
- Calibration highlights (selected):
  - Size of the small economy ω = 0.01
  - Share of restricted households ωr = 015
  - Inverse Frisch elasticity φ = 2
  - Discount factor, unrestricted households βu = 0.9975
  - Discount factor, restricted households βr = 0.9925
  - Cognitive discounting, unrestricted households mu = 0.95
  - Cognitive discounting, restricted households mr = 1
  - Steady-state inflation π = 1.01
  - Long-term bond duration D = 40
  - Transaction cost on long-term bonds ξ = 0.015
  - Price markup μ = 1.15
  - Kimball parameter ψ = -12
  - Calvo probabilities: domestic production θH, θ*F = 0.66; home exports θ*H = 0.88; home imports θF = 0.5
  - Price indexation: home ζ = 0.75; foreign ζ* = 0
  - Elasticity of substitution between home and foreign goods ν = 0.8
  - Home-bias η = 0.75
  - Interest rate smoothing γ = 0.82
  - Interest rate response to inflation γπ = 1.9
  - Interest rate response to output gap γy = 0.125
  - Reinvestment strategy ρ = 0.5525

### Model experiments and comparative scenarios
- Baseline scenario:
  - Covid shock followed by unanticipated inflation surge in both euro area (Foreign) and Emerging Europe (Home); ECB cuts rates to ELB and launches APP QE reaching portfolio holdings of 15 percentage points of GDP.
  - Home central bank also cuts policy rate and launches limited QE.
  - Inflation surge builds for four quarters; EE economy experiences larger inflation hike due to higher weights of food and energy and faster pass-through.
- Isolating pure interest-rate shocks:
  - Aggressive-rate scenario: policy rate raised 12.5bps more than the Taylor-rule prediction in four steps → cumulative 50bps over a year.
  - Spillovers from this tighter-interest-rate path are relatively small.
- Adding quantitative tightening (QT):
  - Gradual and predictable APP unwinding scenario: quarterly pace of reduction of APP holdings of EUR45bn (as envisaged by ECB announcement).
  - Difference between interest-rate-plus-QT scenario and baseline isolates spillovers from interest rate surprise plus QT.
- Comparative findings (interest-rate tightening vs balance-sheet QT):
  - Euro area output takes a bigger hit under pure interest rate strategy.
  - Spillovers to Home (EE) output are smaller under pure interest-rate tightening compared to faster-paced QT.
  - ECB QT has a much larger impact on EE long-term rates and domestic demand than conventional ECB tightening, increasing negative spillovers to EE output.
  - EE inflation can rise under ECB QT due to sharp depreciation of the foreign exchange rate.
  - Example mapping: a 100 basis points fall in foreign long-term rates reduces domestic same-maturity rates by about 35 basis points under a Taylor-type rule (model response mapping).
- Exchange-rate regime comparison:
  - Adverse output spillovers from tighter ECB policy are larger under a fixed exchange rate regime than under inflation targeting with a freely floating currency.
  - Rationale: flexible exchange rate allows depreciation-driven competitiveness gains that mitigate output drops; fixed regimes lose that channel.
- Sacrifice-ratio insight:
  - Interest rate tightening provides a more favorable output-inflation trade-off than balance-sheet tightening in the calibration considered; for the EE the advantage is significant, for the euro area marginal.

### Policy implications and recommendations emphasized
- Composition and pace of tightening matter:
  - Gradual, predictable APP runoff yields smaller spillovers to emerging Europe; accelerated QT can be destabilizing.
  - Conventional tightening via interest rate hikes tends to produce a more favorable inflation-output trade-off for recipient economies than balance-sheet tightening in the calibration used.
- Exchange-rate regime considerations:
  - Fixed exchange rate regimes face larger adverse spillovers from ECB tightening; flexible regimes provide a mitigating channel through competitiveness gains.
- Country fundamentals and buffers:
  - Strong reserve buffers, lower gross financing needs, deeper financial development, and flexible monetary/FX frameworks reduce spillovers.
- Overall policy takeaway:
  - A gradual, predictable reduction in ECB APP holdings is less harmful to emerging European economies than aggressive QT; conventional rate tightening tends to be less damaging to EE output than faster-paced balance-sheet contraction in the scenarios considered.

### Key numeric markers and horizons (preserved)
- Event date: June 9, 2022.
- Event window: T_-6 to T_+6 (six-week periods before and after event; twelve-week window total).
- APP net purchases end as of July 1, 2022; PEPP reinvestments “until at least the end of 2024”.
- ECB intended July raise announced as 25 basis points; actual July 2022 rate hike: 50 basis points; first hike since 2011; largest since 2000.
- Local-projection monetary shock standard deviation: σ = 0.26.
- Data sample for local projections: 16 countries, 1999 Q1 to 2022 Q3.
- Horizon for impulse responses: fifteen quarters; trough of output response occurs after about 10 quarters.
- ECB QE portfolio holdings in baseline reach 15 percentage points of GDP.
- Aggressive policy calibration: policy rate raised 12.5bps more than Taylor-rule prediction in four steps → cumulative 50bps over a year.
- APP unwind calibration: quarterly pace of reduction of APP holdings of EUR45bn.

_Italic source: Appendix I. Country List and Data Sources and Sections 2–5 excerpts from the IMF Working Paper "ECB Spillovers to Emerging Europe: The Past and Current Experience" (material excerpted from the supplied content)._

### Appendix I. Country List and Data Sources ..............................................................................

### Appendix I. Country List and Data Sources

### Overview and purpose
- This appendix is part of a paper studying cross-border spillovers of European Central Bank (ECB) monetary policy to emerging European economies.
- The broader paper uses both empirical and model-based approaches to assess spillovers from ECB conventional (interest rate-based) and unconventional (balance-sheet-based, with a focus on quantitative tightening) policies.

### Key empirical coverage and data sources
- Country coverage: sixteen emerging European economies.
- High-frequency event study data:
  - Frequency: daily.
  - Window: a twelve-week period surrounding the June 2022 ECB policy announcement.
  - Variables: CDS spreads, government bond yields, bilateral exchange rates vis-à-vis the euro.
- Historical analysis data:
  - Frequency: quarterly.
  - Sample period: 1999Q1 to 2022Q4.
  - Variables: real GDP, the unemployment rate, bilateral nominal exchange rates against the euro, short-term policy rates, government bond yields at different maturities, and CDS spreads.
- ECB monetary policy shocks:
  - Identification proxy: three-month Euribor futures rate, used to infer unanticipated changes in the ECB policy stance.
  - Rationale: three-month Euribor futures rate has been shown to be an unbiased and reliable predictor of changes in the euro area policy rate.
- Alternative high-frequency approach considered but not adopted:
  - Euro Area Monetary Policy Event-Study Database (EA-MPD) with intraday OIS rates at tenures including 1, 3, 6 months, 1 to 10-, 15-, and 20-year maturities.

### Channels and transmission mechanisms captured in the data
- Monetary policy response and domestic transmission:
  - Domestic central banks may raise interest rates in response to foreign tightening, affecting bank lending and domestic demand.
- Exchange rate channel:
  - Surprise ECB tightening strengthens the euro and tends to depreciate recipient-country currencies, increasing import costs and potentially fuelling inflation, while enhancing export competitiveness.
  - Noted country exposures: Hungary, Poland, and Türkiye exhibit high proportions of foreign currency-denominated external debt.
- Trade channel:
  - Higher foreign policy rates can reduce demand for traded goods and services from recipient economies, putting downward pressure on inflation and output.
- Bond risk premium and financial channel:
  - Rise in euro area long-term yields and term premia can transmit to emerging European counterparts via integrated capital markets and international portfolio flows.
- Heterogeneity considerations included in the dataset:
  - Exchange rate regime, trade openness, currency invoicing, financial depth, foreign currency liabilities, liquidity and structure of interbank money markets, reserves, gross financing needs, and monetary policy frameworks.

### Main empirical findings referenced in the appendix
- Event and historical analysis results summarized in the paper:
  - Drop in real output reaches 0.5 percent after two years following an ECB monetary tightening shock.
  - Domestic currencies depreciate following ECB tightening.
  - Government bond yields increase by more than one-for-one with ECB tightening.
  - Sovereign spreads increase by up to 60 basis points.
- Country fundamentals matter: weaker fundamentals are associated with larger spillover effects.
- Exchange rate regime effects:
  - Flexible exchange rate regimes (examples in the broader analysis: Albania, Hungary, and Poland) were generally better able to cope with ECB tightening.
  - Pegged or euroized regimes (examples in the broader analysis: Bosnia and Herzegovina, Bulgaria, Kosovo, Montenegro) faced greater challenges.
- Mitigating factors captured in the data: strong reserve buffers and lower financing needs reduce spillovers.

### Model calibration and experiments referenced
- The paper supplements empirical analysis with a two-country DSGE model with financial frictions and segmented asset markets, calibrated to the euro area and a stylized emerging European economy (see Appendix II for parameter values).
- Model experiments examine:
  - The role of the pace and composition of ECB tightening (interest rate hikes versus quantitative tightening).
  - Regime comparisons: fixed exchange rate versus inflation-targeting with a freely floating currency.
- Key model-based insights summarized:
  - Measured and predictable quantitative tightening (QT) yields more manageable spillovers; accelerated QT can be destabilizing.
  - Adverse spillovers are more pronounced under a fixed exchange rate regime than under an inflation-targeting regime with a floating currency.
  - Conventional tightening via interest rate hikes produces a more favorable inflation-output trade-off in recipient economies than balance sheet tightening, largely due to the larger impact of QT on the emerging economy’s long-term rate and aggregate demand.
  - Under ECB QT, inflation in the emerging economy can rise due to sharp depreciation of the foreign exchange rate.

### Variables and country-characteristic controls documented
- Structural and macro variables incorporated to assess heterogeneity in transmission:
  - Exchange rate regime.
  - Level of financial development.
  - Official reserves.
  - Gross financing needs.
  - Type of monetary policy framework.
  - Financial vulnerabilities to currency depreciation.

_Italic source: Appendix I. Country List and Data Sources, from the IMF Working Paper "ECB Spillovers to Emerging Europe: The Past and Current Experience" (material excerpted from the supplied content)._

### 2022. We select the outcome of the June Governing Council meeting as the core event for our study because it

### ECB Spillovers to Emerging Europe: The Past and Current Experience (excerpt)

### Event selection and identification strategy
- Core event: Governing Council meeting on June 9, 2022, chosen because it "represents an unexpected and exogenous shift in monetary policy that financial markets had neither anticipated, nor priced in."
- Event window: twelve-week event window from T_-6 = −6 to T_+6 = +6, with T_0 = June 9, corresponding to six-week periods before and after the event (matching the frequency of regularly scheduled ECB monetary policy meetings).
- ECB policy dummy ECB_{i,t}^{event} takes the value of 0 before the event and 1 after it.
- Country coverage: Albania, Belarus, Bosnia and Herzegovina, Bulgaria, Croatia, Hungary, Kosovo, Macedonia, Moldova, Montenegro, Poland, Romania, Russian Federation, Serbia, Türkiye, and Ukraine.
- June 2022 policy statement items:
  - End net purchases under Asset Purchase Program (APP) as of July 1, 2022, while continuing to fully reinvest principal payments from maturing securities in APP portfolio.
  - Continue reinvesting principal payments from maturing securities purchased under PEPP “until at least the end of 2024”.
  - Left key ECB interest rates unchanged in June but announced intention to raise them by 25 basis points at the July meeting (anticipating further increases in September).
  - July 2022 outcome: ECB raised interest rates by 50 basis points, marking the end of an eight-year period of negative interest rates and representing the first hike since 2011 and the largest since 2000.
- June announcement combined elements of conventional and quantitative tightening; the event study cannot fully differentiate effects of the two.

### Event study (daily data): variables, regression, and controls
- Dependent variables examined: government bond yields at different tenures, CDS spreads, bilateral exchange rates against the euro.
- Regression specification (OLS, controlling for fundamentals and global factors):
  - Y_{i,t} = α + β ECB_{i,t}^{event} + δ ECB_{i,t}^{event} * Z_i + θ Q_t + I_i + ε_{i,t}
  - Z_i: country structural features in the quarter before the ECB June meeting (reserves position; measures of domestic financial development; exchange rate regime; gross financing needs).
  - Q_t: global risk factors (including CBOE VIX, U.S. equity prices, oil price fluctuations).
  - I_i: country fixed effects.
  - High (low) fundamental Z_i identified as value above (below) median across countries.
- Identification intent: isolate impact of ECB announcement from global and country-specific factors.

### Event study findings (daily "before and after" analysis)
- Major results:
  - Emerging European economies experienced strong pressures on exchange rates and government bond yields following the June announcement that signaled upcoming tightening.
  - Bond yields rose amid rising policy rates and risk premia; CDS spreads increased, reflecting higher prices of insuring sovereign debt.
  - Many currencies depreciated significantly against the euro, especially in countries with elevated foreign currency-denominated debt.
  - Some economies (Albania, Moldova, Serbia) intervened in FX markets to stabilize excessive short-term exchange rate volatility.
- Heterogeneity by fundamentals and regimes:
  - Economies with substantial financing gaps experienced more pronounced effects.
  - Economies with higher reserves, more developed financial sectors, and more flexible exchange rate regimes saw more muted impacts.
- Quantification references shown in figures:
  - Figure note: columns show estimated differential impact of an ECB monetary policy tightening by 100 basis point for high and low values of fundamentals; exchange rate regime bar refers to relative difference between floating and fixed regimes.
- Robustness:
  - Findings remain robust after controlling for country-specific factors such as unemployment and inflation, and global factors like the VIX and oil prices.
- Limitation:
  - Event study cannot disentangle effects of conventional versus quantitative tightening within the June statement.

### Local projections method (quarterly analysis)
- Shock identification:
  - Monetary policy shocks identified from three-month Euribor one-year futures rates, following Romer and Romer (2004).
  - Regression to identify shocks includes twelve-month ahead forecasts of euro area GDP growth and inflation (Survey of Professional Forecasters), current and lagged GDP growth and inflation rates, and lags of the short-term rate; residual ε_t captures the non-systematic unexpected part of monetary policy.
  - Monetary shock series: one-standard-deviation ECB monetary tightening shock with σ = 0.26 (noted in figures and text).
- Local projections specification:
  - y_{i,t+h} = α_{i,h} + Σ_{s=0}^h γ_s ε̂_{t-s} + Σ_{s=0}^{h-1} β_{s,h} Z_{i,t-s} + Σ_{s=0}^{h-1} λ_{s,h} X_{i,t-s} + ε_{i,t+h}
  - y_{i,t+h}: endogenous variables (real GDP, government bond yields, CDS, exchange rate).
  - ε̂: constructed monetary shocks.
  - Z: lagged dependent variables accounting for dynamics (four lags included).
  - X: global and country-specific controls (US Federal Funds Rate, VIX, exchange rate regime, reserves position, domestic financial development, fiscal position).
- Data and windows:
  - Quarterly data for 16 countries between 1999 Q1 and 2022 Q3.
  - Impacts examined in a fifteen-quarter window following shocks.
  - Confidence bands: 90 percent, with standard errors two-way clustered at country and quarter levels.
  - Alternative sample: COVID period (2020 Q2 onwards) excluded in some specifications.

### Local projections findings
- Real output:
  - Contractionary ECB monetary shocks have a persistent negative impact on real output growth in emerging Europe.
  - Domestic output decreases following a contractionary shock, with the trough occurring after about 10 quarters.
- Sovereign debt markets and exchange rates:
  - Tightening leads to strong spillovers in sovereign debt markets, with more than one-for-one changes in government bond yields in response to higher ECB interest rates.
  - Sovereign spreads increase substantially and domestic currencies depreciate.
- Role of country fundamentals and regimes (interaction analysis):
  - Conditioning variables include reserves (% of GDP), fiscal balance (% of GDP), public debt (% of GDP), financial sector development (M2/GDP), and monetary/FX policy regime.
  - Figure 5 key patterns:
    - Fixed exchange rate regimes and weak fundamentals (lower reserves, lower financial development) experience more significant negative impacts.
    - Flexible exchange rate regimes and strong fundamentals exhibit resilience: smaller overall shock size and more gradual impact.
- Source of shock matters:
  - Spillovers are negative for pure monetary policy tightening shocks.
  - If tightening is driven by a more positive euro area outlook (information/news component), spillovers could be positive.

### Structural model analysis (two-country DSGE)
- Model features:
  - Two-country, open-economy DSGE model based on Erceg et al. (2024) and Kolasa and Wesołowski (2020).
  - Two types of households: restricted (trade only in long-term bonds; proxy for specialized financial institutions; no transaction cost) and unrestricted (trade in long-term foreign and domestic bonds and short-term domestic bonds; face transaction cost when trading long-term bonds).
  - Asset market segmentation between long- and short-term bonds generates non-trivial effects of central bank interventions in long-term bond markets.
- Calibration and scenarios:
  - Model calibrated to euro area and a small open emerging European economy (see Appendix II for calibration overview in source).
  - Scenario: European economy recovering from pandemic when a strong acceleration in inflation prompts substantial central bank tightening.
- Policy channels studied:
  - Distinguish spillovers from interest rate policy (short-term rates) and balance sheet interventions (long-term rates/QT).
  - Analyze different exchange rate regimes for the small open economy: endogenously determined floating vs exogenous exchange rate peg.
  - Investigate how exchange rate regime buffers pass-through, and role of trade and financial linkages.
- Motivation:
  - Historical QT data are limited (only one round initiated October 2017 and ended September 2019); structural model helps analyze QT effects and complement empirical methods.

### Key numeric points and temporal markers (preserved)
- Event date: June 9, 2022.
- Event window: T_-6 to T_+6 (six-week periods before and after event; twelve-week window total).
- ECB June announcements: end APP net purchases as of July 1, 2022; PEPP reinvestments “until at least the end of 2024”; intended interest rate raise by 25 basis points at July meeting.
- Actual July 2022 rate hike: 50 basis points; first hike since 2011; largest since 2000.
- Local-projection monetary shock standard deviation: σ = 0.26.
- Data sample for local projections: 16 countries, 1999 Q1 to 2022 Q3.
- Horizon for impulse responses: fifteen quarters; trough of output response occurs after about 10 quarters.
- Figures referenced: Figure 1 (timeline), Figure 2 (event study impacts by fundamentals), Figure 3 (Euribor futures and constructed shock), Figures 4a/4b (impulse responses of output, bond yields, CDS, exchange rate), Figure 5 (responses by fundamentals, panels A–D).

*Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024170-print-pdf.pdf*

### 5.   Model   Results

### 5.   Model   Results

### Baseline scenario and shock design
- Baseline comprises a Covid shock followed by an unanticipated inflation surge in both the euro area (Foreign) and the Emerging European (EE) economy (Home).
- Covid shock: modeled as a negative demand shock in both Foreign and Home, triggering a deep recession and inflation drifting below targets.
- ECB response to Covid shock:
  - Cuts the interest rate, hitting the effective lower bound (ELB).
  - Launches a program of asset purchases with portfolio holdings soon reaching 15 percentage points of GDP.
- Home (EE) central bank response to Covid shock:
  - Cuts the policy rate.
  - Launches a more limited QE program.
- Inflation surge: strong demand and cost-push shocks that build for four quarters in both home and foreign economies; described as “synchronous but asymmetric” with the EE economy hit much more strongly (larger inflation hike), related to higher weights of food and energy in the EE CPI basket and faster pass-through of energy prices.
- Post-inflation dynamics:
  - Baseline policy rate follows predictions from a standard Taylor rule in both countries.
  - Output rises initially with strong demand, then falls as drivers fade.
  - Inflation and policy rates decline only gradually.
- Exchange rate responses:
  - Home real exchange rate appreciates after the Covid shock (driven by stronger ECB QE) and then depreciates somewhat after the inflation shocks.
  - When the inflation shock hits EE more forcefully, the real exchange rate can move in the opposite direction.

### Isolating pure interest-rate shocks (aggressive rate policy)
- Starting from the baseline gradual tightening (solid blue line in Figure 7), an aggressive policy scenario raises the policy rate 12.5bps more than the Taylor-rule prediction in four steps, leading to a cumulative monetary policy shock of 50bps over a year.
- Interpretation: difference between this tighter-interest-rate scenario and the baseline is the effect of aggressive ECB interest rate policy.
- Effects:
  - Tighter policy stance is contractionary on euro area GDP, delaying recovery but containing inflation somewhat.
  - Spillover effects from the tighter-interest-rate path are relatively small.

### Adding quantitative tightening (QT) — gradual and predictable APP unwinding
- The tighter interest rate scenario is extended with a gradual and predictable unwinding of the ECB asset purchase portfolio (dash-dotted magenta line), mimicking the APP runoff announced by the ECB in December 2022 at a quarterly pace of reduction of APP holdings of EUR45bn.
- The difference between this scenario and baseline estimates spillovers from an interest rate surprise plus QT.

### Spillovers under alternative tightening strategies (conventional IR vs balance-sheet QT)
- Comparative setup: tighten only interest rates versus contract ECB assets faster, with intervention sizes adjusted to ensure similar effects on euro area inflation.
- Key findings:
  - Euro area output takes a bigger hit under the pure interest rate strategy (dotted green line).
  - Spillovers to Home (EE) output are smaller under pure interest-rate tightening compared to faster-paced QT (dash-dotted blue line).
  - ECB QT has a much larger impact on EE long-term rates and domestic demand than conventional ECB tightening, increasing negative spillovers to EE output.
  - EE inflation rises under ECB QT due to a sharp depreciation of the foreign exchange rate.
- Sacrifice-ratio insight:
  - Interest rate tightening provides a more favorable output-inflation trade-off than balance-sheet tightening in the calibration considered.
  - For the euro area, the sacrifice ratio under interest rate policy is marginally more favorable than under balance-sheet policy; for the EE, it is significantly more favorable.
  - The relative merits in the euro area may depend on calibration and loss function; deeper analysis is left for future research.
- Policy implication highlighted:
  - A gradual, predictable runoff of the APP portfolio (baseline approach) could be in the interest of the region given smaller spillovers to EE.

### Spillovers under alternative foreign-exchange regimes
- Simulations compare spillovers under fixed exchange rate regimes versus inflation targeting with a freely floating currency in the EE economy.
- Findings:
  - Adverse output spillovers from tighter ECB monetary policy tend to be larger under a fixed exchange rate regime compared to an inflation targeting regime with a freely floating currency.
  - This holds for both a tighter interest rate path and faster ECB QT.
  - Rationale: QT is associated with larger downward pressure on the exchange rate of a typical EE economy; depreciation generates competitiveness gains that mitigate output drops when the exchange rate is flexible. Fixed regimes lose this mitigating channel.
- Policy implication:
  - Results underline potential costs of a fixed exchange rate regime when exposed to large, asymmetric external shocks.

### Model mechanics and transmission channels (concise)
- Model: New-Keynesian setup with home bias, local-currency price stickiness, and segmented asset markets (short- and long-term bonds imperfect substitutes due to portfolio transaction costs).
- QE mechanism:
  - Asset purchases reduce long-term bond supply, lowering expected returns on long-term bonds (given fixed short-term policy rate) because transaction costs are an increasing function of long-term bond holdings of unrestricted agents.
  - Lower expected long-rate increases consumption for agents tied to long rates, expanding output.
- Exchange-rate channel:
  - Long-UIP condition implies that a fall in expected returns on foreign long-term bonds (from QE) must lead to a decrease in domestic expected bond returns and/or expected exchange rate appreciation of the foreign currency; QE thus tends to depreciate the currency of the country undertaking QE on impact.
  - If the domestic monetary authority pegs the exchange rate, foreign QE effects transmit fully to domestic long-term rates; if the authority follows a Taylor-type rule, a 100 basis points fall in foreign long-term rates reduces domestic same-maturity rates by about 35 basis points.

### Conclusions (summary of substantive findings and policy takeaways)
- Historical analysis and simulations show that ECB monetary policy generally produces large financial and real spillovers to emerging European countries; the magnitude depends on recipient countries’ fundamentals and policy frameworks.
- Composition and pace of ECB tightening matters:
  - Conventional tightening (interest rate increases) offers a more favorable inflation-output trade-off than balance-sheet tightening in the calibration used, both domestically (euro area) and for spillovers to emerging European economies.
  - Spillovers from QT depend on the speed of balance-sheet reduction: measured and predictable QT yields moderate spillovers; significantly accelerated QT can generate large spillovers.
- Exchange-rate regime matters:
  - Adverse spillovers are more pronounced under fixed exchange rate regimes than under inflation targeting with a freely floating currency.
- Overall policy message: gradual, predictable APP runoff mitigates spillovers to emerging Europe relative to aggressive QT; conventional rate tightening tends to be less harmful to EE output than faster-paced balance-sheet contraction in the scenarios considered.

### Key calibrated values and simulation parameters (selected)
- ECB QE portfolio holdings reach 15 percentage points of GDP (pandemic response).
- Aggressive policy calibration: policy rate raised 12.5bps more than Taylor-rule prediction in four steps → cumulative 50bps over a year.
- APP unwind calibration: quarterly pace of reduction of APP holdings of EUR45bn (as envisaged by ECB announcement).
- Example model response mapping: a 100 basis points fall in foreign long-term rates reduces domestic same-maturity rates by about 35 basis points under a Taylor-type rule.

### Appendix highlights (model calibration excerpts)
- Size of the small economy ω = 0.01
- Share of restricted households ωr = 015
- Inverse Frisch elasticity of labor supply φ = 2
- Discount factor, unrestricted households βu = 0.9975
- Discount factor, restricted households βr = 0.9925
- Cognitive discounting, unrestricted households mu = 0.95
- Cognitive discounting, restricted households mr = 1
- Steady-state inflation π = 1.01
- Long-term bond duration D = 40
- Transaction cost on long-term bonds ξ = 0.015
- Price markup μ = 1.15
- Kimball parameter ψ = -12
- Calvo probabilities: domestic production θH, θ*F = 0.66; home exports θ*H = 0.88; home imports θF = 0.5
- Price indexation: home ζ = 0.75; foreign ζ* = 0
- Elasticity of substitution between home and foreign goods ν = 0.8
- Home-bias η = 0.75
- Interest rate smoothing γ = 0.82
- Interest rate response to inflation γπ = 1.9
- Interest rate response to output gap γy = 0.125
- Reinvestment strategy ρ = 0.5525

*Source: wpiea2024170-print-pdf - 5.   Model   Results*

### References

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*ECB Spillovers to Emerging Europe: The Past and Current Experience Working Paper No. WP/2024/170*

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_Source: https://www.imf.org/-/media/files/publications/wp/2024/english/wpiea2024170-print-pdf.pdf_