Working Paper

Debt and Stabilization Policy: Evidence from a Euro Area FAVAR

Abstract: The Euro-area poses a unique problem in evaluating policy: a currency union with a shared monetary policy and country-specific fiscal policy. Analysis can be further complicated if high levels of public debt affect the performance of stabilization policy. We construct a framework capable of handling these issues with an application to Euro-Area data. In order to incorporate multiple macroeconomic series from each country but, simultaneously, treat country-specific fiscal policy, we develop a hierarchical factor-augmented VAR with zero restrictions on the loadings that yield country-level factors. Monetary policy, then, responds to area-wide conditions but fiscal policy responds only to its country level conditions. We find that there is broad quantitative variation in different countries'' responses to area-wide monetary policy and both qualitative and quantitative variation in responses to country-specific fiscal policy. Moreover, we find that debt conditions do not diminish the effectiveness of policy in a significant manner, suggesting that any negative effects must come through other channels.

Keywords: Government spending; monetary policy; European Monetary Union; debt;

JEL Classification: C32; E58; E62;

https://doi.org/10.20955/wp.2017.022

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2017-10-13

Number: 2017-22

Pages: 55 pages