EMU has led to increased stability and convergence of financial markets in euro area

michaelehrmann0, marcelfratzscher0, refet.gurkaynak, erictswanson0, Mon, 09/17/2007

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One desired outcome at the time when EMU was conceived was having countries with less well-anchored expectations benefit from a more credible monetary policy-making framework. The authors of DP6456 focus on the extent to which monetary union has led to the integration of financial markets across the euro area, and in particular investigate the effects of two dimensions: the unification of bond markets, and the anchoring of long-run inflation expectations. The findings suggest that the common monetary policy has been a major contributor towards convergence in both dimensions, which in fact are intimately related as long-term bond yields in any given country are very sensitive to financial market expectations of long-run inflation.

First, the authors investigate to what extent the sovereign bond markets in France, Germany, Italy and Spain - the four largest euro area countries - have become integrated alongside the unification of the currency and monetary policy. In a unified bond market, bonds of different markets (at the same maturity) should respond similarly to the same impulse, whether or not there are constant differences in risk or liquidity spreads. The authors’ analysis shows that convergence took place not only for the level of bond yield across countries, but also for their day-to-day movement, both unconditionally in terms of volatilities and conditionally in terms of their responses to major macroeconomic announcements. This process seems to have been stronger just before and after the monetary union in 1999.

The authors then turn to the question of long-run inflation expectations in the euro-area countries. They test whether the volatility of very far forward interest rates has decreased over time, as would be expected if long-run inflation expectations in a country are well anchored. Since EMU, Italy and Spain in particular have seen their long-term interest rates become much lower, much less volatile and much better anchored in response to news. They have converged to about the same level as the remaining stable rates in France and Germany. Conditional analysis further proves that heterogeneity in the effects of macroeconomic surprises on far-ahead rates has diminished since EMU and has even been eliminated over time, thus underlining not only market integration but also the credibility that financial markets attach to monetary policy in the euro area.

 
DP6456 Convergence and Anchoring of Yield Curves in the Euro Area

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URL:  http://www.cepr.org/pubs/new-dps/dplist.asp?dpno=6456.asp

Topics:  EU policies Financial markets

Tags:  monetary policy, credibility, EMU, euro area, bond markets, convergence, anchoring

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