The Transmission of Monetary Policy via Common Cycles in the Euro Area

Abstract: We use a FAVAR model with proxy variables and sign restrictions to investigate the role of the euro area's common output and inflation cycles in the transmission of monetary policy shocks. Our findings indicate that common cycles explain most of the variation in output and inflation across member countries. However, Southern European economies exhibit a notable divergence from these cycles in the aftermath of the financial crisis. Building on this evidence, we demonstrate that monetary policy is homogeneously propagated to member countries via the common cycles. In contrast, country-specific transmission channels lead to heterogeneous country responses to monetary policy shocks. Consequently, our empirical results suggest that the divergent effects of ECB monetary policy are attributable to heterogeneous country-specific exposures to financial markets, rather than to dis-synchronized economies within the euro area.