The cost channel of monetary policy transmission : evidence from the Euro Area

Abstract

This paper studies the validity of the cost channel of monetary policy transmission in the euro area. The idea behind the aforementioned channel is that an increase in short-term interest rates, and in turn lending rates, puts upward pressure on inflation. The reason is that firms borrow funds in order to pay for their factors of production. An increase in interest rates increases the cost of labor and in turn firms will increase their prices to recoup the costs. In order to test this effect an interest rate augmented Phillips curve was jointly estimated with a Taylor rule. This study found no empirical evidence in favor of the cost channel with the potential reasons being small sample bias or misspecification in modelling monetary policy by using the Taylor rule.