hould the Euro Area be Run as a Closed Economy?

This paper studies monetary policy in the Euro area looking at the
variable most directly related to current and expected monetary policy,
the yield on long term government bonds. We find that the level of longterm
rates in Europe is almost entirely explained by U.S. shocks and by
the systematic response of U.S. and European variables (inflation, short
term rates and the output gap) to these shocks. Our results suggest in
particular that U.S. variables are more important than local variables
in the policy rule followed by European monetary authorities: this was
true for the Bundesbank before EMU and has remained true for the
ECB, at least so far. Using closed economy models to analyze monetary
policy in the Euro is thus inconsistent with the empirical evidence on the
determinants of Euro area long-term rates. It is also inconsistent with
the way the Governing Council of the ECB appears to make actual policy
decisions.