Monetary policy models : lessons from the Eurozone crisis

Abstract

This paper theoretically and empirically investigates the puzzling decade-long concurrence of expansionary monetary and fiscal policies, decreasing credit flows, fall in price levels, and sluggish real activity observed in the Euro area from the outset of the 2007–2008 financial crisis. To this end, we propose a monetary general equilibrium model that clarifies the transmission mechanisms, debt–deflation channels, and the paramount role of financial leverage decisions underlying these peculiarities. On this basis, a vector error correction model is specified which confirms the theoretical predictions and provides insights into the elements specific to the long-term relations. In addition, the estimated impulse response functions document the associated short-term dynamics outlining the debt–deflation mechanism.