The impact of an interest rate tightening in our model is consistent with existing evidence for the euro area and with widely accepted theoretical prior: (i) output and prices decrease (the latter more persistently); (ii) consistent with a liquidity effect, money falls below the baseline; (iii) unemployment grows and labour productivity falls, resulting in a pro-cyclical response of the latter.
...The public deficit widens significantly after the restrictive monetary policy shock, in line with the expected budget worsening due to lower tax receipts following the slowdown in economic activity induced by the interest rate hike and with the outlays related to the automatic stabilizers at work. (Bonci, 2011:5-6) (emphasis added)It wouldn't surprise me if Mario Draghi was given an advanced copy of this paper to read on his first day as head of the ECB. If so, it might explain why he was so decisive in lowering interest rates upon his appointment. In many respects, the findings in the paper appear to support the view that the decisions of Mr. Draghi's predecessor to raise interest rates earlier this year were ill-advised.
Indeed, while it does not explicitly aim to do so, the study provides evidence as to why Jean-Claude Trichet's final actions as ECB President may have had the effect of worsening the economic situation in Europe by increasing both unemployment and reliance on automatic stabilizers, and thus enlarging public sector deficits in a pro-cyclical manner. As far as I know, this is the first study examining the impact of interest rate policy on the different sectors of the economy within the euro area as a whole.
Bonci, Riccardo, "Monetary Policy and the Flow of Funds in the Euro Area", ECB Working Papers Series, No. 1402, December 2011