MONETARY POLICY TRANSMISSION MECHANISMS AND CURRENCY UNIONS: A VECTOR ERROR CORRECTION METHOD APPROACH TO A TRANS-TASMAN CURRENCY UNION

Alfred A. HAUG
Özer KARAGEDİKLİ (Reserve Bank of New Zealand)
Satish RANCHHOD

Transmission mechanisms are the channels through which monetary policy affects macroeconomic variables, such as output and inflation. Differences in transmission mechanisms can generate asymmetric behaviour among currency union partners when they experience shocks. This has the potential to widen existing cyclical variation between members of a currency union. We examine the similarity of transmission mechanisms in New Zealand and Australia and consider the implications this has for a currency union between the two economies. We examine these using the Vector Error Correction Methodology (VECM). Our analysis indicates that the transmission mechanisms in New Zealand and Australia do display important differences. In particular the differing size of the GDP changes and speed of the CPI adjustments in response to monetary policy shocks in each country suggest that, if New Zealand were to join a currency union with Australia, it may be subject to monetary policy that it is not appropriate for its conditions. Consequentially, the costs of a joint currency agreement are likely to be larger for New Zealand.