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

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  • Arnold, Ivo J.M.

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.

Suggested Citation

  • Arnold, Ivo J.M., 2024. "The effect of fragmentation risk on monetary conditions in the euro area," Journal of International Money and Finance, Elsevier, vol. 146(C).
    • Handle: RePEc:eee:jimfin:v:146:y:2024:i:c:s0261560624000962
    DOI: 10.1016/j.jimonfin.2024.103109
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    More about this item

    Keywords

    Monetary union; Fragmentation risk; IS curve; Monetary conditions index;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E53 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Deposit Insurance
    • F45 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Macroeconomic Issues of Monetary Unions

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