Author(s): Sebastian Hauptmeier, Fédéric Holm-Hadulla, Théodore Renault
Date published: Dec 2022
SUERF Policy Brief, No 491*
By Sebastian Hauptmeier (European Central Bank), Fédéric Holm-Hadulla (European Central Bank), and Théodore Renault (Geneva Graduate Institute)
*This policy brief has been published as a VoxEU column on 5 December 2022 (Hauptmeier, Holm-Hadulla, and Renault 2022). Disclaimer: The views expressed here are those of the authors and do not necessarily reflect those of the European Central Bank.
JEL codes: C32, E32, E52.
Keywords: Monetary Policy, Risk Sharing, Regional Heterogeneity, Local Projections, Quantile Regressions.
Download: SUERF Policy Brief, No 491 (0.56 MB)
Monetary policy and risk sharing are often viewed as independent mechanisms to address different types of shocks: monetary policy counteracts aggregate fluctuations arising from common shocks; risk sharing counteracts idiosyncratic fluctuations in specific regions due to asymmetric shocks. In this column, we show that these mechanisms do not just operate alongside each other: instead, the strength and composition of risk sharing fundamentally shapes the real effects of monetary policy, as well as its regional incidence.
The literature on optimal currency areas establishes a clear division of labor in the pursuit of macroeconomic stabilization objectives (Mundell, 1961; Kenen, 1969; Farhi and Werning, 2017). Monetary policy is to limit fluctuations in average macroeconomic outcomes in response to symmetric shocks. Risk sharing instead should limit the dispersion in macroeconomic outcomes across the currency union by facilitating a geographically differentiated adjustment to asymmetric shocks.
An important, but so far under-explored, aspect in implementing this division of labour is that the impact of these macroeconomic stabilization tools may interact. If monetary policy exerts a uniform impact on different members of a currency union, its role in limiting average economic fluctuations is unaffected by the role of risk sharing in limiting economic dispersion. But a growing literature has documented that monetary policy transmits unevenly, owing e.g. to differences in economic structures and initial conditions (e.g. Ampudia et al., 2018; Eichenbaum, Rebelo, and Wong, 2018; Hauptmeier, Holm-Hadulla, and Nikalexi, 2020). This, in turn, may render the impact of monetary policy dependent on the risk-sharing architecture of a currency union. For instance, if the tax and transfer system systematically reallocates funds from less to more affected regions, the aggregate impact of a monetary policy tightening may be different than in a scenario without this type of fiscal risk sharing.
In a recent paper, we provide empirical evidence on the relevance and nature of these interactions, based on regionally disaggregated data for the euro area (Hauptmeier, Holm-Hadulla, and Renault, 2022).
Interaction between risk sharing and monetary policy
As a first step, we rely on the well-established framework by Asdrubali, Sorensen, and Yosha (1996) to estimate the degree and composition of risk sharing across regions within individual euro area countries.1
The methodology allows us to estimate the amount of risk shared through the factor-market, fiscal, and credit-market channel. We then feed these estimates into a local projections model to study how the risk-sharing intensity affects the transmission of monetary policy shocks to the real economy.
Our results suggest that risk sharing dampens the real effects of monetary policy. Figure 1a presents the response of regional output to a 100 basis point interest rate hike for different percentiles of the risk-sharing distribution. In the upper quartile of the distribution, regional output decreases by 1.9% after two years, whereas in the lower quartile the corresponding contraction is 0.4 percentage point deeper.
Figure 1: Monetary policy effects on output conditional on risk sharing intensity
Note: Vertical axes refer to the impact of a 100 basis point rate hike on regional GDP (in %). Horizontal axes refer to the horizon of the IRFs (in years). Solid lines denote point estimates and shaded areas denote 90% confidence bands. Red (blue) lines depict the estimates for the upper (lower) quartiles of risk-sharing intensity for panels a) to c) and deciles of risk-sharing intensity for panel d). Poor regions are defined as the lowest decile of the GDP distribution.
Disentangling private and public risk sharing effects
As regards individual channels, both private risk sharing, via factor and credit markets, as well as public risk sharing, cushion the impact of a monetary policy tightening. However, the channels differ in their time profiles. Private risk-sharing channels tend to dampen the monetary policy shock contemporaneously and up to one year after the shock (Figure 1b
Fiscal risk sharing instead mitigates the economic consequences of a rate hike over longer horizons (Figure 1c
). Public and private risk-sharing channels therefore emerge as complements, in that they operate at different time horizons.
Heterogeneity across regions
The interaction between risk sharing and monetary policy may vary between more or less prosperous regions. For instance, the stabilization role of fiscal instruments might be reinforced if net transfers are targeted towards poorer regions, which would tend to be populated by households with a larger propensity to spend. To explore this aspect, we rely on the quantile fixed effects estimator of Machado and Santos Silva (2019) to estimate the impact of exogenous changes in monetary policy across the regional GDP distribution. Our quantile regression analysis reveals pronounced differences in the degree to which fiscal risk sharing especially determines the transmission of monetary policy to rich versus poor regions. With weak fiscal risk sharing, GDP in poor regions does not only exhibit a strong contraction, but the impact proves highly persistent. By contrast, with strong fiscal risk sharing, the GDP contraction in poor regions is markedly shallower and turns insignificant at longer horizons (Figure 1d). Fiscal risk sharing thus emerges as particularly instrumental in preempting long-lived hysteresis effects of monetary policy in regions with weak economic performance already prior to the shock.
These findings offer relevant insights for the debate on the institutional setup of the Economic and Monetary Union (Bénassy-Quéré et al., 2018). First, they suggest that heterogeneity in the capacity to absorb shocks via fiscal and market-based channels could contribute to an uneven transmission of monetary policy across jurisdictions. Second, the results point to the benefits of fiscal risk sharing in mitigating the tendency for regional economic divergence to intensify in policy tightening cycles. Third, they indicate that changes to the risk-sharing architecture of an economy may have a major bearing on the aggregate effects of a given change in monetary policy stance.
Ampudia, Miguel, Dimitris Georgarakos, Michele Lenza, Jiri Slacalek, Oreste Tristani, Philip Vermeulen, and Giovanni L. Violante. 2018. “Household Heterogeneity and the Transmission of Monetary Policy in the Euro Area.” CEPR. August 14, 2018. https://cepr.org/voxeu/columns/household-heterogeneity-and-transmission-monetary-policy-euro-area.
Asdrubali, Pierfederico, Bent Sorensen, and Oved Yosha. 1996. “Channels of Interstate Risk Sharing: United States 1963–1990.” The Quarterly Journal of Economics 111 (4): 1081–1110.
Bénassy-Quéré, Agnès, Markus K Brunnermeier, Henrik Enderlein, Emmanuel Farhi, Marcel Fratzscher, Clemens Fuest, Pierre-Olivier Gourinchas, et al. 2018. “Reconciling Risk Sharing with Market Discipline: A Constructive Approach to Euro Area Reform.” CEPR Policy Insight No. 91 (91): 24.
Eichenbaum, Martin, Sergio Rebelo, and Arlene Wong. 2018. “State-Dependent Effects of Monetary Policy: The Refinancing Channel.” CEPR. December 2, 2018. https://cepr.org/voxeu/columns/state-dependent-effects-monetary-policy-refinancing-channel.
Farhi, Emmanuel, and Iván Werning. 2017. “Fiscal Unions.” American Economic Review 107 (12): 3788–3834. https://doi.org/10.1257/aer.20130817.
Hauptmeier, Sebastian, Fédéric Holm-Hadulla, and Katerina Nikalexi. 2020. “Monetary Policy and Regional Inequality.” CEPR. April 22, 2020. https://cepr.org/voxeu/columns/monetary-policy-and-regional-inequality.
Hauptmeier, Sebastian, Fédéric Holm-Hadulla, and Théodore Renault. 2022. “Risk Sharing and Monetary Policy Transmission.” CEPR. 2022. https://cepr.org/voxeu/columns/risk-sharing-and-monetary-policy-transmission.
———. 2022. “Risk Sharing and Monetary Policy Transmission.” Working Paper Series 2746. European Central Bank. https://econpapers.repec.org/paper/ecbecbwps/20222746.htm.
Kenen, Peter B. 1969. “The Theory of Optimum Currency Areas : An Eclectic View.” Monetary Problems of the International Economy, Monetary problems of the international economy. - Chicago, Ill. [u.a.] : Univ. of Chicago Press, ISBN 0-226-55065-6. - 1969, p. 41-60, .
Machado, José A. F., and J. M. C. Santos Silva. 2019. “Quantiles via Moments.” Journal of Econometrics 213 (1): 145–73.
Mundell, Robert A. 1961. “A Theory of Optimum Currency Areas.” The American Economic Review 51 (4): 657–65.
About the authors
Sebastian Hauptmeier is a Lead Economist in the Directorate General Economics of the European Central Bank. He also worked for the European Commission, the German Ministry of Finance and as a researcher at the Centre for European Economic Research (ZEW) in Mannheim. He holds a Master’s degree and a PhD in Economics from Ludwig-Maximilians-University Munich. His research interests cover fiscal policies as well as monetary and financial economics.
Fédéric Holm-Hadulla is Head of the Policy Assessment Section in the Directorate General Monetary Policy of the European Central Bank. Prior to joining the ECB, Fédéric worked as a researcher at the Ifo Institute for Economic Research in Munich. He holds a Master’s degree and a PhD in economics from Ludwig-Maximilians-University Munich and from Friedrich-Alexander-University Erlangen-Nuremberg, respectively. His research interests cover monetary and financial economics, with particular emphasis on factors giving rise to heterogeneity in the transmission of monetary policy.
Théodore Renault is a PhD student at the Department of Economics of the Graduate Institute of International and Development Studies (IHEID) in Geneva. His research interests are monetary economics, macroeconomics and banking. He has recently worked as a Junior Economist at the OECD Economics Department and as a trainee and consultant at the European Central Bank. He holds a Bachelor degree from Paris Dauphine University and a Master degree from Paris School of Economics.
Risk sharing refers to the notion that economic agents attempt to insure their income and consumption streams against fluctuations in the business cycle of their country or region. The analysis relies on NUTS-2 level data, following the Eurostat classification, which subdivides national territories into regions. The use of regional data allows us to capture the amount of risk shared within a country (intranational risk sharing) and between countries (international risk sharing).
The dampening effect of risk sharing through the credit market channel is of the same magnitude as that of the factor market channel.