Once EMU has begun, the European Central Bank will want to know how different, both in timing and magnitude, the regional effects of interest rate changes will be across participating countries. New CEPR research offers some guidance.

Monetary union means a single monetary policy with a common interest rate set in Frankfurt by the European Central Bank (ECB). How will that policy be transmitted to individual members of the economic and monetary union (EMU) and their constituent regions? What if, for example, the cost of a disinflation episode falls disproportionately on countries with both a financial structure that spreads contractionary policy widely and a wage-price structure that is relatively inflexible? For a country with the German predilection for low inflation, the burden might be tolerable; it might be harder to bear for a country like France.

The regional impact of monetary tightening is rarely at the forefront of debate, but it is one of the issues addressed by Rudi Dornbusch, Carlo Favero and Francesco Giavazzi in the latest issue of Economic Policy. What will be the effect of an ECB decision to raise interest rates?, they ask. For a start, countries with a relatively large share of GDP in construction, capital goods and consumer durables will be more exposed. And certain regions will be more exposed simply because industrial activity is concentrated in these sectors.

Interest rate moves will also change the external exchange rate of the euro, another channel for differential effects across countries. A rise in interest rates will generally lead to appreciation of the euro, and hence both a loss of competitiveness and a real income gain from terms of trade improvements. These effects may be differentially distributed, especially since openness to extra-European trade differs significantly across countries. For example, the United Kingdom, Ireland and, to some extent, Germany, are relatively more exposed to fluctuations in transatlantic competitiveness.

Even more important will be the role of initial conditions. Tight money hurts large debtors far more than countries with moderate debt levels and good balance sheets. Belgium and Italy stand out with their huge debts and special vulnerability, and the problem will be compounded, at least for Italy, by the below average quality of bank balance sheets.

So how should the ECB assess the potentially differential impact of its monetary policy? To answer this question, Dornbusch and his colleagues construct a model of the ‘monetary transmission mechanism’ in six European countries. Simulations of the model suggest that an EMU-wide change in interest rates will have the largest impact on real activity in Italy and Sweden, smaller in France and the United Kingdom, and smallest in Germany and Sweden. Of course, Sweden and the United Kingdom will not be ‘first wave’ members of EMU, but these issues are still relevant if and when they decide to join.

What explains these differences? In Sweden, the fast transmission of monetary policy to output could be related to the importance of bank credit; to the short maturity of lending contracts; to the key role of collateral; and to the balance sheet position of households, the financial liabilities of which exceed 100% of total disposable income. In Italy, short-term bank credit and the balance sheet position of households work in opposite directions, but the first must clearly dominate.

In the United Kingdom and, to a lesser extent, in France, the speed of transmissionof monetary policy could be related to the role of the capital markets in the financing of firms. Collateral could also be important, especially in France.

Germany and Spain show surprisingly low responsiveness to changing interest rates: the importance of bank credit and of relationships between banks and industry underlie the slow and small impact of interest rate changes on German output.

The ECB cannot neglect these ‘asymmetries’ in national monetary transmission mechanisms. A monetary tightening will produce an uneven distribution of output losses across the monetary union. For example, and perhaps most importantly, since an EMU-wide increase in interest rates affects German output by a relatively smaller amount and with longer lags than elsewhere, Germany will be partially sheltered from the tightening and will possibly experience higher-than-average inflation.

Since the asymmetries are related to different financial structures, the speed at which these structures converge under EMU will be an important factor in eliminating the asymmetries. For example, the development of a liquid market for corporate bonds will reduce the role of banks in the intermediation of savings and help financial structures to converge.

Policy too can play an important role. Differential capital adequacy requirements, for example, could encourage banks to shift from variable to fixed rate loans and mortgages. And tax changes could reduce gearing in countries where household debt is relatively high and encourage companies to shift from debt to equity financing.

The ECB will also need to focus on the importance of the euro’s external exchange rate when setting monetary policy. Dornbusch et al compute an ECB ‘Monetary Condition Index’ of 2.2. This means that inside EMU, the effect on output of a 1% change in interest rates will be equivalent to that of a 2.2% appreciation of the euro against the dollar.

The corresponding number for the United States is roughly 10, indicating a relatively weak impact of the dollar exchange rate on US output. For Germany, the number is 1.4, indicating a much stronger effect of fluctuations in the external value of the Deutsche mark on the German economy. So while the ECB is likely to care about the euro-dollar exchange rate less than the Bundesbank cares about the Deutsche mark-dollar rate, it may still be much more concerned than the Fed.

It is hard enough to operate monetary policy without the benefit of continuity; it is even harder when policy targets suddenly turn European, and with an economic structure that remains largely unexplored. The simple question ‘what is the effect of a 100 basis points increase in the ECB Funds rate on European output and over what time period?’ does not have an answer at present. These researchers’ examination of the monetary transmission mechanism provides a first guess but for two reasons, the problem for policy-makers is certain to be more complicated.

First, in combination with financial innovation and the process of market deregulation already in progress, the euro will change the way European financial markets work. This will lead to corresponding changes in the monetary transmission mechanism, which will in turn have an important bearing on the operation of monetary policy. In such circumstances, any notion of stable relationships between a monetary aggregate and target variables is unlikely to last. This, incidentally, is an important argument against relying on monetary aggregates as indicators for monetary policy.

Second, but with less certainty than financial restructuring, the process of wage and price setting may well evolve as economic actors adjust to operating more clearly in a single market with a common currency. We know very little about how this evolution might proceed but there seems little doubt that it will complicate the operation of European monetary policy.