Comovements and heterogeneity in the euro area analyzed in a non-stationary dynamic factor model

This paper seeks to assess comovements and heterogeneity in the euro area by fitting a nonstationary dynamic factor model (Bai and Ng, 2004), augmented with a structural factor setup (Forni and Reichlin, 1998), to a large set of euro-area macroeconomic variables observed between 1982 and 2003. This framework allows us to estimate stationary and non-stationary common factors and idiosyncratic components, to identify the structural shocks behind the common factors and assess their transmission to individual EMU countries. Our most important findings are the following. EMU countries share five common trends. However, the source of non-stationarity of individual countries’ key macroeconomic variables is not only pervasive. Instead, most countries’ output and inflation are also affected by long-lasting idiosyncratic shocks. Unweighted dispersion is primarily due to idiosyncratic shocks rather than the asymmetric spread of common shocks. However, the latter seems to be the main driving force of weighted dispersion of output at the end of the 1980s and the beginning of the 1990s and again from 1999 on and of inflation in the mid-1980s and the mid-1990s. To examine the transmission of common shocks to individual EMU countries in more detail, we identify five structural common shocks, namely two euro-area supply shocks, one euro-area demand shock, one common monetary policy shock and a US shock. We find similar output and inflation responses across countries (with some exceptions), and similarity generally increases with the horizon.