Working Paper: CEPR ID: DP10828
Authors: Maximo Camacho; Danilo Leiva-Leon; Gabriel Pérez-Quiros
Abstract: Previous studies have shown that the effectiveness of monetary policy depends, to a large extent, on the market expectations of its future actions. This paper proposes an econometric framework to address the effect of the current state of the economy on monetary policy expectations. Specifically, we study the effect of contractionary (or expansionary) demand (or supply) shocks hitting the euro area countries on the expectations of the ECB?s monetary policy in two stages. In the first stage, we construct indexes of real activity and inflation dynamics for each country, based on soft and hard indicators. In the second stage, we use those indexes to provide assessments on the type of aggregate shock hitting each country and assess its effect on monetary policy expectations at different horizons. Our results indicate that expectations are responsive to aggregate contractionary shocks, but not to expansionary shocks. Particularly, contractionary demand shocks have a negative effect on short term monetary policy expectations, while contractionary supply shocks have negative effect on medium and long term expectations. Moreover, shocks to different economies do not have significantly different effects on expectations, although some differences across countries arise.
Keywords: Business cycles; Inflation cycles; Monetary policy
JEL Codes: C22; E32; E37
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| aggregate contractionary shocks (E19) | monetary policy expectations (E52) |
| contractionary demand shocks (E31) | short-term monetary policy expectations (E52) |
| contractionary supply shocks (E31) | medium and long-term monetary policy expectations (E52) |
| ECB's reaction function to negative demand shocks (E52) | market perception of monetary policy expectations (E52) |