Over the past decade, the countries of central Europe have become more alike in many ways. As the new members of the European Monetary Union (EMU) prepared for the birth of the euro on January 1, 1999, their economic policies became substantially more uniform. All eleven countries in the new euro area have virtually eliminated inflation and taken serious steps toward fiscal consolidation.(1) As their monetary and fiscal policies have adjusted to meet these common goals, the countries' business cycle fluctuations appear to have become more synchronized as well.(2) While this makes the job of the Eurosystem (the European Central Bank plus the central banks of the eleven monetary union member countries) easier, numerous difficult challenges remain. Primary among these is the making of policy in the face of the possibility that it will have differential impacts across the countries of the euro area.
The task facing the Eurosystem is even more complex than that facing countries with stable monetary regimes, where the measurement of the national and regional impact of policy has already proved to be extremely difficult. The creation of the Eurosystem constitutes a regime shift in virtually every sense of the term. The introduction of the euro seems sure to prompt adjustments in the economies of the member countries, and these adjustments will probably alter the relationship between the actions of the central bank and the real economy. That is, the monetary transmission mechanism of the countries in the euro area will change, making the job of the new European Central Bank even more difficult than it is already. But how quickly will it change, and what will it become?
To answer these questions, we must understand the fundamental determinants of the impact of policy actions on output and inflation. For insight into these determinants, I turn to the modern views of the monetary transmission mechanism, which assign a central role to financial structure. Kashyap and Stein (1997) provide a starting point; they focus on the importance of the banking system and go on to emphasize the distributional effects of monetary policy changes. The conventional wisdom has always been that some industries are more sensitive to interest rate changes than others, and so changes in policy-controlled interest rates have differential effects across industries. The view based on financial structure both formalizes this reasoning and takes it one step further by noting that some firms are more dependent on banks for financing than others, and that this is true both across and within industries. According to this "lending view" of the transmission mechanism, monetary policy actions change the reserves available to the banking system, thereby affecting the willingness of banks to lend and, ultimately, the supply of loans. How this mechanism will affect individual firms depends on the financing methods available to them. Monetary policy has a bigger impact on firms that are reliant on banks for their financing. Furthermore, healthier banks will be able to adjust to the policy-induced reserve changes more easily than other banks will.
The distributional effects implied by the lending view of monetary policy transmission have clear implications for the euro area and the Eurosystem. Countries in which firms are more bank dependent and banking systems are less healthy will be more sensitive to the Eurosystem's decisions to change interest rates. This brings me to the first question I will address in this paper: Is there evidence that the impact of monetary policy innovations varies across countries with the strength and scope of the banking system?
With this in mind, I examine differences in the size, concentration, and health of national banking systems, as well as in the availability of nonbank sources of finance. I find, consistent with the most casual observation, that banking system characteristics vary dramatically across the countries of the European Union (EU). …