Monetary Policy Independence in the EU: An Impulse Response Analysis

Abstract

While a monetary union imparts several economic benefits to its members, it also imposes a cost in terms of loss of monetary policy independence. The current Eurocrisis has made this a central issue to be confronted by the ten non-Eurozone EU members who might be considering adopting the euro: Bulgaria, the Czech Republic, Denmark, Hungary, Latvia, Lithuania, Poland, Romania, Sweden, and the UK. In this context, it is an interesting problem to quantify the degree of monetary policy independence enjoyed by these countries, which they would presumably forfeit should they choose to join the Euro. Using interbank rates as a proxy for monetary policy, we apply a pairwise VAR framework to model the short-term dynamics between the policies of each of these ten countries and those of the European Central Bank. In each case, we further examine the orthogonalized impulse response functions to determine the long-term response of the country’s interbank rates to a shock in the European Interbank Rate. Our results suggest that the ten countries have at best a limited degree of monetary policy independence; of the group, Poland and Romania possess the least degree of independence, whereas Sweden seems to have the most. We put our results in the context of the cost/benefit calculus of adopting the euro.