nep-mon New Economics Papers
on Monetary Economics
Issue of 2017‒01‒22
twenty-two papers chosen by
Bernd Hayo
Philipps-Universität Marburg

  1. Short-term risk premiums and policy rate expectations in the United States By Leo Krippner; Michael Callaghan
  2. Monetary policy transmission mechanism in Poland.What do we know in 2015? By Mariusz Kapuściński; Andrzej Kocięcki; Halina Kowalczyk; Tomasz Łyziak; Jan Przystupa; Ewa Stanisławska; Anna Sznajderska; Ewa Wróbel
  3. The risk-adjusted monetary policy rule By Nakata, Taisuke; Schmidt, Sebastian
  4. Ambiguous Policy Announcements By Claudio Michelacci; Luigi Paciello
  5. Economic Crises and the Eligibility for the Lender of Last Resort: Evidence from 19th century France. By V. Bignon; C. Jobst
  6. Exchange rate forecasting and the performance of currency portfolios By Crespo Cuaresma, Jesus; Fortin, Ines; Hlouskova, Jaroslava
  7. Loan production and monetary policy By LG Deidda; J.E. Galdon-Sanchez; M. Casares
  8. Money growth and aggregate stock returns By Böing, Tobias; Stadtmann, Georg
  9. Quantitative Easing by the Fed and International Capital Flows By Sameer Khatiwada
  10. Globalization, Market Structure and Inflation Dynamics. By S. Guilloux-Nefussi
  11. The Inflation Targeting Debate By Malte Rieth
  12. Chinese Foreign Exchange Reserves, Policy Choices and the U.S. Economy By Neely, Christopher J.
  13. National natural rates of interest and the single monetary policy in the Euro Area. By S. Fries; J.-S. Mésonnier; S. Mouabbi; J.-P. Renne
  14. Does bitcoin reveal new information about exchange rates and financial integration? By Pieters, Gina
  15. How effective quantitative easing is in relation to the Gold Standard? A historical approach based on the US experience By Economou, Emmanouel/Marios/Lazaros; Nickos, Kyriazis; Papadamou, Stephanos
  16. Measuring the Distributions of Public Inflation Perceptions and Expectations in the UK By Murasawa, Yasutomo
  17. Inflation bias in Latin America By Pacheco, André Sanchez; Tenani, Paulo Sérgio
  18. Macroeconomic stabilization, monetary-fiscal interactions, and Europe’s monetary union By Corsetti, Giancarlo; Dedola, Luca; Jarociński, Marek; Maćkowiak, Bartosz; Schmidt, Sebastian
  19. Money supply and inflation in Europe: Is there still a connection? By Diermeier, Matthias; Goecke, Henry
  20. Market volatility, monetary policy and the term premium By Sushanta K Mallick; Madhusudan Mohanty; Fabrizio Zampolli
  21. Parsing Financial Frictions Underlying Bank Lending Fragmentation during the Euro Area Crisis By Matthieu Darracq Paries; Pascal Jacquinot; Niki Papadopoulou
  22. Eurozone’s Leader and its Followers: Are their Markets Integrated Enough? By Nikolaos Giannellis; Minoas Koukouritakis

  1. By: Leo Krippner; Michael Callaghan (Reserve Bank of New Zealand)
    Abstract: In recent years, Federal Funds Futures rates in the United States have been persistently lower than the Federal Reserve’s projections and analysts’ surveyed expectations of the Federal Funds rate. We present a case for the difference based on risk premiums, the compensation that holders of securities demand for bearing risk, or return they are prepared to forego to avoid risk. In particular, it may be that market participants are at present willing to pay an insurance value to own high-quality interest rate securities (i.e. accept a negative risk premium) because such securities would outperform in the event of an unexpected economic downturn. Financial market factors, such as the expanded Federal Reserve balance sheet from quantitative easing, may also be contributing to negative risk premiums. We estimate risk premiums from a term structure model and find they are of a sign and magnitude that would readily account for the differences mentioned in the first paragraph, and are plausible economically. Besides providing a rational reconciliation for the differences, a further implication from our negative risk premium estimates is that the expected path of the Federal Funds rate in the United States may currently be materially higher than might be inferred directly from the prevailing rates on the current series of Federal Funds Futures contracts.
    Date: 2016–09
  2. By: Mariusz Kapuściński; Andrzej Kocięcki; Halina Kowalczyk; Tomasz Łyziak; Jan Przystupa; Ewa Stanisławska; Anna Sznajderska; Ewa Wróbel
    Abstract: In this study we present a complex analysis of the monetary policy transmission mechanism in Poland. We find that this mechanism is quite stable, although the relative strength of its channels has been changing. In particular, the decline in the role of the exchange channel over the recent years has been accompanied by the growing role of credit (and the credit channel) and the growing anticipation of economicagents. In connection with the latter, in the assessment of the economic impact of the monetary policy, not only decisions in the scope of short-term interest rates but also central bank communication should be taken into account.
    Keywords: Monetary transmission mechanism, Poland
    JEL: E43 E52
    Date: 2016
  3. By: Nakata, Taisuke; Schmidt, Sebastian
    Abstract: Macroeconomists are increasingly using nonlinear models to account for the effects of risk in the analysis of business cycles. In the monetary business cycle models widely used at central banks, an explicit recognition of risk generates a wedge between the inflation-target parameter in the monetary policy rule and the risky steady state (RSS) of inflation - the rate to which inflation will eventually converge - which can be undesirable in some practical applications. We propose a simple modification to the standard monetary policy rule to eliminate the wedge. In the proposed risk-adjusted policy rule, the intercept of the rule is modified so that the RSS of inflation equals the inflation-target parameter in the policy rule. JEL Classification: E32, E52
    Keywords: effective lower bound, inflation targeting, monetary policy rule, risk, risky steady state
    Date: 2016–11
  4. By: Claudio Michelacci (EIEF and CEPR); Luigi Paciello (EIEF and CEPR)
    Abstract: We study the effects of monetary policy announcements in a New Keynesian model, where ambiguity-averse households with heterogeneous net financial wealth use a worst-case criterion to assess the credibility of announcements. The announcement of a future loosening of monetary policy leads to the rebalancing of financial asset positions, it can cause credit crunches, and it may prove to be contractionary in the interim before implementation. This is because the households with positive net financial wealth (creditors) are those that are most likely to believe the announcement, due to the potential loss of wealth from the prospective policy easing. And when creditors believe the announcement more than debtors, their expected wealth losses are larger than the wealth gains that debtors expect. So aggregate net wealth is perceived to fall, and the economy can contract owing to lack of aggregate demand, which is more likely when the inequality in wealth is more pronounced. We evaluate the importance of this mechanism, focusing on the start of the ECB's practice of offering forward guidance in July 2013. The infl ation expectations of households have responded in accordance with the theory. After matching the entire distribution of European households' net financial wealth, we find that the ECB's announcement is contractionary in our model. In general, redistributing expected wealth may have perverse effects when agents are ambiguity-averse.
    Date: 2017
  5. By: V. Bignon; C. Jobst
    Abstract: This paper shows that a central bank can more efficiently mitigate economic crises when it broadens eligibility for its discount facility to any safe asset or solvent agent. We use difference-in-differences panel regressions and emulate crises by studying how defaults of banks and non-agricultural firms were affected by the arrival of an agricultural disease. We exploit the specificities of the implementation of the discount window to deal with the endogeneity of the access to the central bank to the arrival of the crisis and local default rates. We find that broad eligibility reduced significantly the increase in the default rate when the shock hit the local economy. A counterfactual exercise shows that defaults would have been 10% to 15% higher if the Bank of France would have implemented the strictest eligibility rule. This effect is identified independently of changes in policy interest rates and the fiscal deficit.
    Keywords: discount window, collateral, Bagehot rule, central bank, default rate
    JEL: E32 E44 E51 E58 N14 N54
    Date: 2017
  6. By: Crespo Cuaresma, Jesus (Vienna University of Economics and Business (WU), Austria Wittgenstein Centre for Demography and Global Human Capital (WIC), International Institute for Applied Systems Analysis (IIASA), Austrian Institute of Economic Research (WIFO)); Fortin, Ines (Research Group Financial Markets and Econometrics, Institute for Advanced Studies); Hlouskova, Jaroslava (Research Group Financial Markets and Econometrics, Institute for Advanced Studies and Thompson Rivers University, Canada)
    Abstract: We examine the potential gains of using exchange rate forecast models and forecast combination methods in the management of currency portfolios for three exchange rates, the euro (EUR) versus the US dollar (USD), the British pound (GBP) and the Japanese yen (JPY). We use a battery of econometric specifications to evaluate whether optimal currency portfolios implied by trading strategies based on exchange rate forecasts outperform single-currency and the equally weighted portfolio. We assess the differences in profitability of optimal currency portfolios for different types of investor preferences, different trading strategies, different composite forecasts and different forecast horizons. Our results indicate that the benefits of integrating exchange rate forecasts from state-of-the-art econometric models in currency portfolios are sensitive to the trading strategy under consideration and vary strongly across prediction horizons.
    Keywords: currency portfolios, exchange rate forecasting, trading strategies, profitability
    JEL: G02 G11 E20
    Date: 2017–01
  7. By: LG Deidda; J.E. Galdon-Sanchez; M. Casares
    Abstract: We examine optimal monetary policy in a New Keynesian model with unemployment and financial frictions where banks produce loans using equity as collateral. Firms and households demand loans to finance externally a fraction of their flows of expenditures. Our findings show amplifying business-cycle effects of a more rigid loan production technology. In the monetary policy analysis, the optimal rule clearly outperforms Taylor (1993) rule. The optimized interest-rate response to the external finance premium turns significantly negative when either banking rigidities are high or when financial shocks are the only source of business cycle fluctuations.
    Keywords: external finance,optimal monetary policy,business cycles
    Date: 2016
  8. By: Böing, Tobias; Stadtmann, Georg
    Abstract: We empirically evaluate the predictive power of money growth measured by M2 for stock returns of the S&P 500 index. We use monthly US data and predict multiperiod returns over 1, 3, and 5 years with long-horizon regressions. In-sample regressions show that money growth is useful for predicting returns. Higher recent money growth has a significantly negative effect on subsequent returns of the S&P 500. An out-of-sample analysis shows that a simple model with money growth as a single predictor performs as goods as the constant expected returns model, while models with several predictor variables perform worse than those simple models.
    Keywords: Money growth,M2,Stock Market,S&P 500,Stock Returns,Out-of-Sample
    JEL: C58 E44 E47 G14 G17
    Date: 2016
  9. By: Sameer Khatiwada (IHEID, Graduate Institute of International and Development Studies, Geneva and ILO Regional Office Bangkok)
    Abstract: By employing a novel dataset on international capital flows, this paper examines the impact of Fed’s quantitative easing (QE) policies on flows to emerging markets economies (EMEs) and the EU countries. Episodes of QE are examined separately, with the last episode divided between pre- and post-tapering. We find evidence that QE was associated with an increase in capital inflow, while tapering was associated with a period of retrenchment. The magnitude of the impact varied by different episodes of QE and the types of assets (bonds or equities). Our results show that the EU countries behaved differently than the EMEs. We also find support for the importance of “pull factors” and individual country characteristics for capital inflows. However, the paper shows that episodes of QE accounted for most of the variation in capital inflows during 2008-2014. G20 statements during the episodes of QE show that countries are increasingly cognizant of their inability to control flows and have thus called for better monetary policy coordination to avoid excessive volatility and negative spillovers.
    Keywords: Quantitative Easing (QE), spillovers, capital flows, emerging market economies (EMEs)
    JEL: E44 E52 E58 F32 F41 F42
    Date: 2017–01
  10. By: S. Guilloux-Nefussi
    Abstract: The sensitivity of inflation to domestic slack has declined in developed countries since the mid-1980s. This article shows why this might result from globalization favoring concentration. To do so, I add three ingredients to an otherwise standard general equilibrium two-country new-Keynesian model. (1) Strategic interactions generate a time-varying desired markup; (2) endogenous entry and (3) heterogeneous productivity engender a self-selection of the most productive firms (which are also the largest ones) in international trade. Hence, the weight of large firms in domestic production increases in response to a fall in international trade costs. These large firms transmit less marginal cost fluctuations to price adjustments, rather absorbing them into their desired markup to protect their market share. At the aggregate level, this leads to domestic inflation reacting less to real activity fluctuations.
    Keywords: Inflation, Impact of Globalization, Strategic Interactions, Market Structure, Phillips Curve
    JEL: E31 F41 F62
    Date: 2016
  11. By: Malte Rieth
    Abstract: Inflation targeting has become one of the most prominent monetary regimes around the globe. Proponents argue that it reduces the dynamic inconsistency problem of monetary policy and thereby stabilises prices, which in turn promotes growth. Opponents, on the other hand, say that by focusing on price stability inflation targeting neglects other important policy objectives, such as financial stability, and thereby contributed to the built up of the global financial crisis. This roundup summarises the arguments made in the debate. It concludes that no consensus has emerged in the empirical literature about whether inflation targeting improves macroeconomic performance.
    Date: 2017
  12. By: Neely, Christopher J. (Federal Reserve Bank of St. Louis)
    Abstract: China is both a major trading partner of the United States and the largest official holder of U.S. assets in the world. The value of Chinese foreign exchange reserves peaked at just over $4 trillion in June 2014, but has since declined to $3.19 trillion as of August 2016. This very large decline is in foreign exchange reserves is unprecedented and some analysts have speculated that continued sales of these (mostly U.S.) assets might significantly impact the U.S. and global economies. This article explains the reasons for this large decline in official assets, what China’s policy choices are, and how these choices could affect the U.S. economy.
    Keywords: Monetary policy; central banks and their policies; foreign exchange; current account
    JEL: E52 E58 F31 F32
    Date: 2017–01–09
  13. By: S. Fries; J.-S. Mésonnier; S. Mouabbi; J.-P. Renne
    Abstract: Using a semi-structural approach, we jointly estimate time-varying national natural real rates of interest for the largest four economies of the Euro area over 1999-2016 and discuss the associated challenges for the single monetary policy. We find evidence of an increased dispersion of real equilibrium rates across major Euro area economies during the Euro area sovereign debt crisis. This dispersion translated into significantly diverging national real interest rate gaps, a synthetic metrics of the perceived monetary policy stance, between core and Southern countries. Real interest rate gaps have nonetheless converged towards zero in all four economies as of 2014, suggesting that it took the acceleration of unconventional policies since mid-2013 to eventually restore the conditions for a really common monetary policy in the Euro area.
    Keywords: Euro area countries, natural rate of interest, common monetary policy, fragmentation
    JEL: C32 E32 E43 E52
    Date: 2016
  14. By: Pieters, Gina (Trinity University)
    Abstract: I show that the prices of the internationally traded crypto-currency bitcoin can be used to estimate a currency’s unofficial exchange rate and capital controls at a daily interval. Two important bitcoin features are documented: (1) Bitcoin-based exchange rates approximate the behavior, but not the level, of unofficial exchange rates, and (2) Bitcoin prices contain a bitcoin-trend term and must be appropriately normalized prior to being used for this purpose. Bitcoin-based exchange rates reveal that (3) there is no consistent pattern of Granger causality between unofficial rates and official rates by exchange rate regime or barriers at the daily frequency, and (4) that countries can engage in short-interval capital controls.
    JEL: F31 F33 G15 O17
    Date: 2016–12–01
  15. By: Economou, Emmanouel/Marios/Lazaros; Nickos, Kyriazis; Papadamou, Stephanos
    Abstract: The current paper contributes to the recent discussion in the US which has to do with the level of efficiency of the QE practices being implemented since 2008 and afterwards until today. It also analyses the basic argumentation of the academics and social and political groups who are in favour of the restoration of the Gold Standard. Thus, the analysis offers a critical approach concerning the US monetary practices linked to the implementation of the gold standard regimes as against to the quantitative easing policies. We conclude that although there are both arguments in favour of or against the abandonment of the QE policies in the US, the implementation (through restoration) of the Gold standard doctrines is very difficult to materialize, especially when an economy faces or has already faced the negative and detrimental side-effects of recession.
    Keywords: US monetary policy, Gold Standard, Quantitative Easing
    JEL: E62 F33 G18 N2
    Date: 2017–01–07
  16. By: Murasawa, Yasutomo
    Abstract: The Bank of England/GfK NOP Inflation Attitudes Survey asks individuals about their inflation perceptions and expectations in eight ordered categories with known boundaries except for an indifference limen. With enough categories for identification, one can fit a mixture distribution to such data, which can be multi-modal. Thus Bayesian analysis of a normal mixture model for interval data with an indifference limen is of interest. This paper applies the No-U-Turn Sampler (NUTS) for Bayesian computation, and estimates the distributions of public inflation perceptions and expectations in the UK during 2001Q1--2015Q4. The estimated means are useful for measuring information rigidity.
    Keywords: Bayesian, Indifference limen, Information rigidity, Interval data, Normal mixture, No-U-turn sampler
    JEL: C11 C25 C46 C82 E31
    Date: 2017–01–16
  17. By: Pacheco, André Sanchez; Tenani, Paulo Sérgio
    Abstract: This paper accesses the presence of inflation bias in major Latin American Economies over the past decade. Using a small-scale New Keynesian DSGE model and Bayesian Techniques, the time-varying neutral rate of interest is estimated for major Latin American economies. Then the deviations in the policy rate from the neutral rate are overlapped with deviations in current inflation from target. This simple procedure allows the identification of three different regimes of monetary policy – too easy, too restrictive and appropriate. The main result is that Latin American Central Banks often set monetary policy too easy. Analogously, the same conclusion is found if one compares the policy rate with a Taylor Rule-based interest rate aimed at the center of the inflation target range. Such analysis provides evidence of inflation bias in the region, with the exception of Chile.
    Date: 2016–08–25
  18. By: Corsetti, Giancarlo; Dedola, Luca; Jarociński, Marek; Maćkowiak, Bartosz; Schmidt, Sebastian
    Abstract: The euro area has been experiencing a prolonged period of weak economic activity and very low inflation. This paper reviews models of business cycle stabilization with an eye to formulating lessons for policy in the euro area. According to standard models, after a large recessionary shock accommodative monetary and fiscal policy together may be necessary to stabilize economic activity and inflation. The paper describes practical ways for the euro area to be able to implement an effective monetary-fiscal policy mix. JEL Classification: E31, E62, E63
    Keywords: eurobond, government bonds, joint analysis of fiscal and monetary policy, lower bound on nominal interest rates, self-fulfilling sovereign default
    Date: 2016–12
  19. By: Diermeier, Matthias; Goecke, Henry
    Abstract: Since the outbreak of the European financial and economic crisis in 2008, the monetary policy of the European Central Bank (ECB) has been in crisis mode. The central bankers are attempting to get a grasp on the current low inflation rates and inflation expectations by, among other things, introducing a policy of extreme quantitative easing. The expansion of the Eurosystem's balance sheet was problem-free on this occasion, and the ECB also managed to eventually increase the money supply again. However, ensuring that the growth in the money supply transmutes into higher inflation or inflation expectations has been much more difficult. [...]
    JEL: E31 E52 E58
    Date: 2016
  20. By: Sushanta K Mallick; Madhusudan Mohanty; Fabrizio Zampolli
    Abstract: Based on empirical VAR models, we investigate the role of (option-implied) stock and bond market volatilities and monetary policy in the determination of the US 10-year term premium. Our preliminary findings are that an unexpected loosening of monetary policy - through a cut in the federal funds rate in the pre-crisis sample or an increase in bond purchases post-Lehman - typically leads to a decline in both expected stock and bond market volatilities and the term premium. However, while conventional monetary policy boosts economic activity in the precrisis period, bond purchases are found to have no statistically significant real effects postcrisis. Second, expected equity market volatility (VIX) is found to be more important than bond market volatility (MOVE). Pre-crisis, a shock to the VIX leads to a concomitant rise in the MOVE, a contraction of economic activity, a fall in broker-dealer leverage and a rise in the term premium, consistent with pro-cyclical swings in market liquidity. Post-crisis, an innovation to the VIX is instead associated with a drop in the term premium, suggesting the prevalence of flight to quality effects.
    Keywords: bond market volatility, VIX, unconventional monetary policy, quantitative easing, long-term interest rate, term premia
    Date: 2017–01
  21. By: Matthieu Darracq Paries (European Central Bank); Pascal Jacquinot (European Central Bank); Niki Papadopoulou (Central Bank of Cyprus)
    Abstract: The euro area experience during the financial crisis highlighted the importance of financial and sovereign risk factors in macroeconomic propagation, as well as the constraints that bank lending fragmentation would pose for monetary policy conduct in a currency union. Focusing specifically on the credit intermediation process, we claim that sources of impairments in the monetary policy transmission mechanism can arise from five distinct segments, related both to the demand and the supply of credit, namely: (i) deposit spread, (ii) market-funding cost spread, (iii) bank capital charges, (iv) compensation for expected losses and (v) competitive wedge. These intermediation wedges constitute specific types of financial frictions which may independently be the epicenter of financial disturbances. Against this background we design a DSGE model spanning the relevant "financial wedges" at play during the crisis, together with its cross-country heterogeneity within the euro area, focusing on Germany, France, Italy, Spain, and rest-of-euro area. Our main results are the following. First, we show that the cross-country heterogeneity of micro-structure of financial frictions are relevant to explain the divergence in lending rates. Second, sovereign risk, bank risk and corporate risk have been the most relevant channels to explain the financial heterogeneity observed during the banking crisis (bank capital shock). Third, the corporate risk channel has been the main source of impairment of the monetary policy transmission across euro area countries. Fourth, a 10 pp increase in the annual debt-to-GDP ratio triggers a surge in sovereign yields by than 300 bps and 200 bps for Italy and Spain respectively. Fifth, cross-border financial linkages are more important for Italy and Germany and affect for both countries the transmission of bank capital shocks.
    Keywords: DSGE models, banking, financial regulation, cross-country spillovers, bank lending rates
    JEL: E4 E5 F4
    Date: 2016–12
  22. By: Nikolaos Giannellis (Department of Economics, University of Crete, Greece); Minoas Koukouritakis
    Abstract: The establishment of the European Economic and Monetary Union (EMU) was admittedly a remarkable step in the direction of enhancing economic integration among European countries. The launch of the common currency was expected to lead to price stability, lower transaction costs, stronger intra-euro trade relationships and thus, to higher growth for country-members. This optimistic view is obviously related to McKinnon’s (1963) contribution to the theory of Optimum Currency Areas (OCA). However, a fundamental weakness of the EMU, such as the lack of homogeneity across member-countries, should not be ignored. A number of divergent factors, such as dissimilar national policies (apart from the monetary policy) and different national regulations on goods and labour markets, may increase the possibility of emergence of asymmetric shocks in the Eurozone. On the other hand, this view is related to Mundell’s (1961) original contribution to OCA theory. Having in mind the aforementioned heterogeneity and the resulting asymmetries across countries, academics and policy makers focus on answering the question of whether the EMU achieved its goals. The main reservation in this analysis arises from the presence of asymmetries and the lack of autonomous monetary policy for member-countries. This is because an asymmetric shock could be managed by an exchange rate adjustment. However, in a monetary union, like the EMU, this is not the case. Thus, the main question is whether the common monetary policy (including the exchange rate policy) can achieve higher growth rates and higher economic and financial integration in the Eurozone. De Grauwe (2009) argues that in the first decade of euro’s life and before the debt crisis arises, there is little evidence that the euro caused higher growth rates in the Eurozone. On the other hand, nobody can argue that the euro had negative impacts on growth. However, it is also true that the EMU suffers from significant design weaknesses, which became more evident and stronger during the sovereign debt crisis. What may be indicative of the progress of economic integration among EMU members is that real effective exchange rates deviate among them, thereby implying that their competitive positions have diverged (De Grauwe, 2009, 2010). Northern European countries such as Germany, Austria and the Netherlands, gain in terms of international competitiveness, while competiveness in international trade for Southern European countries, such as Greece, Italy and Spain, has deteriorated. In this context, the present paper aims to find whether economic and financial integration has increased among countries after the creation of the EMU. To be precise, we investigate whether EMU countries as well as selected non-EMU countries are financially integrated with Germany, which is the leading country in the EMU as it has the highest influence on the common monetary policy. We initially expect that the euro has led to integrated commodity and capital markets in the Eurozone because of stronger trade linkages among its member-countries. On the other hand, given the high degree of heterogeneity across countries and the absence of (intra-euro) exchange rate fluctuations, it is doubtful that higher economic integration can be achieved among EMU countries (especially for those that are structurally different from Germany). The existence of economic and financial integration between Germany and the rest of the Eurozone’s countries (and the non-EMU countries) is tested through two well-known international parity relationships, i.e. the Purchasing Power Parity (PPP) and the Uncovered Interest Parity (UIP). The empirical validity of the PPP hypothesis implies that goods markets are integrated, while the validity of the UIP condition implies the existence of capital market integration between countries. A survey on the related empirical literature implies that the introduction of the euro may have failed to increase commodity and financial markets integration among EMU countries. Koedijk et al. (2004) find evidence in favour of the PPP hypothesis within the euro area only when common mean reversion among countries is assumed. Setting Germany as the benchmark country and assuming heterogeneous mean reversion coefficients, their evidence is strengthened only for France, Finland and Spain, while they found no evidence regarding the validity of the PPP between the EMU and major non-EMU countries. Furthermore, Christidou and Panagiotidis (2010) and Wu and Lin (2011) report that the adoption of the euro has weakened the evidence in favor of the PPP. Similarly, Huang and Yang (2015) find that after the launch of the euro, the evidence in favour of the PPP is stronger for non-EMU countries rather than EMU countries. When it comes to capital markets integration (i.e. the UIP hypothesis), Kim et al. (2006) find that the degree of integration among European bond and stock markets has declined after the introduction of the euro. However, the above studies have tested the PPP and UIP hypotheses only as independent parity conditions. This implies that the possibility that deviations from the PPP equilibrium are utilized by investors when forming expectations has been overlooked. Motivated by the seminal papers of Johansen and Juselius (1992) and Juselius (1995), we expect that PPP deviations may interact with UIP deviations. In the present paper, we extend the empirical literature on economic and financial integration in the Eurozone by testing the PPP and the UIP jointly. To the best of our knowledge, we argue that the present paper is the first that tests jointly the PPP and UIP conditions between Germany (as the leading economy of the EMU) and the remaining EMU countries. Another contribution of the paper is that, compared to the majority of the empirical studies in the literature, it uses more accurate price indices. Specifically, we utilise constructed Traded-goods Price Indices (TPI) instead of Consumer Price Indices (CPI) in order to avoid the presence of non-traded goods prices, which biases negatively the empirical validation of the PPP hypothesis. Moreover, we use state-of-the-art time series econometric techniques, which allow the presence of structural breaks in cointegration analysis. Admittedly, the launch of the euro in 1999 and the global financial crisis of 2007 have altered the behaviour of variables under consideration. Hence, these two facts have caused an equal number of structural breaks, which should not be ignored by our analysis. Finally, the use of Germany as a benchmark country allows us to shed more light on Germany’s leading role in the Eurozone. Does the degree of economic integration between Germany and the rest of the Eurozone’s countries allow the characterisation of Germany as the representative EMU country? Given Germany’s domination in the Eurozone, a number of policy-related issues arise for the future of the EMU.
    Keywords: Eurozone,markets integration,PPP,UIP
    JEL: C3 F3 F4
    Date: 2016–09–24

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