Business cycle, interest rate and money in the euro area: A common factor model

Abstract

In this paper we model and analyze the contemporaneous correlation between interest rate, monetary aggregates, production and prices (of consumer goods, financial assets and real estate) of the euro area. To do this, firstly we estimate a common cyclical factor by means of an unobserved component model with the common factor located in variations in the underlying growth rates, that is, accelerations and decelerations of the variables. The variables mentioned share a significant cyclical factor being all procyclical except for narrow money. Finally we offer an explanation of this empirical finding based on the monetary policy strategy of interest rate pegging followed by the European Central Bank. In this regard, the shared cyclical information suggests (a) that inflation should be considered as a phenomenon that affects the whole economy, and therefore all prices, and (b) that monetary indicators such as monetary aggregates may contribute to the assessment of inflationary risks throughout the cycle.