The effect of fragmentation risk on monetary conditions in the euro area

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Abstract

This paper measures the output effects of financial fragmentation in the euro area by estimating an extended IS curve. Using a panel approach, we find that two fragmentation measures are significantly related to the output gap: sovereign spreads and spreads in the long-term cost of borrowing of the private sector. We use these output effects to construct a Monetary Conditions Index (MCI) for euro area countries. This index summarizes the combined effect of the monetary policy stance and financial fragmentation. We show that the MCI approach is well-suited to capture cross-country differences in a fragmentation-enhanced measure of the monetary policy stance. Using this metric, we find that during the sovereign debt crisis, the cross-country dispersion of MCI's based on sovereign spreads was much larger than that based on the private cost of borrowing. We also show that convergence is slower for MCI's based on sovereign spreads. We conclude that the causes of fragmentation in monetary conditions may change over time, and that this has implications for the appropriate policy response.

Original languageEnglish
Article number103109
JournalJournal of International Money and Finance
Volume146
DOIs
Publication statusPublished - Aug 2024

Bibliographical note

JEL classification: E52, E53, F45

Publisher Copyright: © 2024 The Author(s)

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