How does monetary policy affect investment in the euro area?

• By Elena Durante, Annalisa Ferrando, and Philip Vermeulen[1] We set out to analyse the monetary policy transmission mechanism by documenting how the annual investment of more than one million firms in Germany, Spain, France and Italy responded to monetary policy shocks between 2000 and 2016.
• This confirms that monetary policy is affecting firms investment through two different channels.
• On the other hand, as young firms are more likely to face financing constraints, their stronger than average reaction can be explained by the balance sheet channel of monetary policy transmission.

Introduction

• Monetary policy affects firms investment through both an interest rate channel and a balance sheet channel.
• First, through the interest rate channel, monetary policy can affect firms demand for capital as an input into the production process.
• This is because interest rates affect decisions on saving or investing and can boost aggregate demand.
• The external finance premium is the difference between the cost of borrowing funds externally and generating them internally.
• Another reason why the impact on firms investment varies is the height of the external finance premium they face.
• This article explains how we analyse these two channels of monetary policy transmission in the euro area, i.e.
• by documenting the heterogeneous reaction of firms investment to monetary policy shocks (Durante, Ferrando and Vermeulen, 2020).

Data and estimation method

• We use firm-level data from the four largest economies in the euro area (Germany, Spain, France and Italy) to construct a large and rich dataset covering more than one million firms throughout 2000-16.
• As a proxy for the euro area policy rate we use the high-frequency monetary policy shock series from Jarociski and Karadi (2020).
• Since firm-level investment data are annual, we construct an annual monetary policy shock data series by aggregating the monthly shocks into twelve-month totals.
• We split the firms into different groups, based on what we already know about firms being affected differently by different transmission channels.
• Younger firms have shorter credit histories and should therefore be more vulnerable than older ones to any tightening of credit conditions.

Findings

• how firms investment reacts to a tightening of monetary policy.
• The investment rate of the average firm does not react initially, but drops by 3.4 percentage points in the year following the monetary policy shock.
• In the second year after the shock, the investment rate remains at this lower level.
• Chart 1 Average investment reaction to a monetary policy shock
• firms below 10 years of age, react more strongly to a surprise than the average firm.
• Similarly, firms that produce durables react more strongly than firms providing services.
• Chart 2 illustrates that a combination of these characteristics leads to substantial differences in firms reactions to monetary policy.
• One year after the surprise, the investment rate of young firms in the durables sector drops by 5.0 percentage points.
• [2] Mature firms, between 10 and 20 years of age, exhibit a reaction within those two extremes (4.4 percentage points for mature firms producing durables and 2.9 percentage points for mature firms providing services).

Conclusions

• In the aftermath of a monetary policy shock, firms that produce durables cut back their investment more than firms providing services.
• Young firms also react more, indicating that the balance sheet channel of monetary policy is having an impact.
• Ultimately, these findings provide a deeper understanding of the transmission of euro area monetary policy to the real economy.
• They point to important differences across firms a feature that is not yet routinely embedded in the standard macroeconomic models.

References