From shocks to cycles - an examination of Euro area economic cycles

It is often the case that the key stumbling block for policy formation is limited knowledge of the way the macroeconomy works. Along with the introduction of a common currency, the interest and need for business cycle analysis at the Euro area level has increased. For this reason, at the present time business cycle researrh for the Euro area has an added significance, given current efforts to understand the workings of the Euro area economy, in terms of the impulse - real, monetary and international - and propagation mechanisms that drive the cycle, so as to design Euro-wide policies. The Euro area's internal mechanisms are explored by using various shock-basedm odels to investigate, first, how much of the Euro area business cycle is due to various shocks - be they real or nominal - and second, whether these shocks explain the dampening in the Euro, area business cycle over the last two decades. This so-called 'great moderation' - the decline in volatility for the Euro area is measured to be just over 40 percent during the past two decades - has only recently motivated economists to ask why business cycles over the past decade are now less volatile across the developed world than was the case in the 1970s and 1980s. These lines of enquiry are extended to investigate the role the Euro area economy plays in the wider global economy by examining the importance of international shocks on the Euro area economy. Linking in with the moderation literature, the study explores whether international shocks have been a key contributing factor behind the decline in business cycle volatility. Little, if any, work examining these issues for the Euro area have been yet undertaken. Allowing for caveats, the results show permanent productivity shocks - modelled using the balanced growth assumptions - to have had a significant role in driving output fluctuations for the Euro area, though they are not quite as important as claimed by real- business-cycle theory. The results also go on to show that permanent shocks explain a larger proportion of the decline in output volatility than is the case with monetary shocks. The estimation undertaken in chapters 4 and 5 show that despite the moderation in business cycle volatility being associated with structural change in the early 1990s, benign business cycles in the Euro area have been mom down to 'good luck' than good policies, such as changes in the priority of monetary policy. Finally, consistent with the good luck hypothesis, the results show output growth to have become more forecastable - as measured by the mean-squared-forecast-error - over the last two decades. Although, this improvement is constrained mainly to asset price variables, with little improvement in the forecasting power of monetary aggregates.