Assessing Monetary Policy in the Euro Area: a Factor-Augmented VAR Approach

Following the tenth anniversary of Stage III of the European Monetary Union, this study assesses the effects of monetary policy shocks in the euro area in the period during which there is a common monetary policy in Europe. In order to overcome the omitted information problem of small-scale vector autoregression (VAR) models, we combine the VAR methodology with dynamic factor analysis, a recent time-series technique for the analysis of large data sets. Using the factor-augmented vector autoregressive (FAVAR) approach of Bernanke et al. (2005), we summarise the in-formation contained in a large set of macroeconomic time series with a small number of estimated factors and use them as regressors in recursive VARs to evaluate the impact of the non-systematic component of the ECB’s actions. Overall, our results suggest that the inclusion of factors in the VAR allows us to obtain a more coherent picture of the effects of monetary policy innovations, both by achieving responses easier to understand from the theoretical point of view and by increasing the preci-sion of such responses. Moreover, to the extent that we include in the econometri