Asymmetry and the Problem of Aggregation in the Euro Area

This paper highlights the implications for EU macroeconomic policy at a relatively disaggregated level when key economic relationships are nonlinear or asymmetric. Using data for the EU and OECD countries we show that there are considerable non-linearities and asymmetries in the Phillips and Okun curves. High unemployment has a relatively limited effect in pulling inflation down while low unemployment can be much more effective in driving it up. Downturns in the economy are both more rapid and sustained in driving unemployment up than recoveries are in bringing it down. There is considerable variety in these relationships and in IS curves across not just countries but also sectors and regions.

Introduction: The euro area has a single monetary policy for quite a diverse region. The range of that diversity is illustrated in Table 1 for inflation growth and measures of economic structure. While it is widely appreciated that monetary policy is a ‘blunt instrument’ and that what is appropriate for the euro economy as a whole may have adverse effects both for individual sectors and for particular geographical parts of the area, some of the consequences of this for the setting of policy have been little discussed. Currently euro area policy simulations are either conducted with models that use euro level aggregated data or which handle the euro countries separately (with appropriate cross-country constraints) and aggregate the results. Such aggregations are usually either unweighted or based on GDP or similar weights. However, these straightforward approaches are based on the assumption that the behaviour we seek to model is largely linear over the relevant range. In this paper we show that there are strong grounds for believing that there are considerable asymmetries and non-linearities in inflationary behaviour and monetary transmission. Ignoring these could have substantial adverse effects on particular sectors, regions and member states within the euro area.

Author: David G Mayes, Matti Virén

Source: Research Discussion Papers, Bank of Finland

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