Following Germany’s Lead: Using International Monetary Linkages to Identify the Effect of Monetary Policy on the Economy
IMF Working Papers, April 1, 2005
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Bibliographic details
- Published: April 1, 2005
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451861051.001
Summary and Main Findings
- Forward-looking behavior on the part of the monetary authority leads least squares estimates to understate the true growth consequences of monetary policy interventions.
- Instrumental variables estimates of the impact of interest rates on real output growth are presented for several European countries, using German interest rates as the instrument.
- The difference between least squares and instrumental variables estimates provides bounds for the degree of endogeneity in monetary policy.
- Results confirm a considerable downward bias of estimates that do not account for potential forward-looking monetary policy decisions.
- The bias is higher for countries whose monetary policy was more independent of Germany.
Methodology and Analytical Approach
- Estimation approaches: least squares and instrumental variables (IV) estimates.
- Instrument used: German interest rates serve as the instrument for domestic interest rates in other European countries.
- Purpose of IV strategy: to identify the causal effect of interest rates on real output growth while accounting for forward-looking monetary policy that induces endogeneity in least squares estimates.
- The IV–LS difference is used to bound the degree of policy endogeneity.
Policy Implications and Interpretation
- Studies that rely on least squares estimates without accounting for forward-looking monetary policy likely understate the true impact of monetary policy on real output growth.
- Policy analysis and monetary policy evaluation should account for potential endogeneity arising from forward-looking central bank behavior.
- Countries with greater monetary-policy independence from Germany exhibit larger downward biases in least squares estimates, implying stronger need for IV approaches in those contexts.
Subjects and Keywords
- Subject: Banking, Econometric analysis, Exchange rate arrangements, Exchange rates, Financial services, Foreign exchange, Inflation, Prices, Production, Production growth, Real interest rates, Vector autoregression
- Keywords: bias of estimate, central bank, effect of monetary policy, Exchange rate arrangements, Global, Inflation, IV estimate, least squares, least squares estimate, monetary policy decision, monetary policy intervention, national interest, Production growth, Real interest rates, Vector autoregression, WP
Source: IMF Working Papers landing page for "Following Germany’s Lead: Using International Monetary Linkages to Identify the Effect of Monetary Policy on the Economy" (Working Paper No. 2005/086).