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This paper analyzes the first part of the stock market channel of monetary policy in the euro area. We find heterogeneous reactions of euro area stock markets to unexpected ECB’s interest rate decisions. Splitting all markets into two groups, covering the stock markets reacting significantly to monetary policy shocks and the ones which do not, each sub-group reveals a higher degree of homogeneity. Interestingly, the markets, which react significantly to unexpected interest rate decisions are the markets with the highest stock market capitalization. In general, we find ECB’s decisions to be well anticipated by stock markets.

Similar transmission processes of interest rate decisions among member countries are a precondition for an effective monetary policy in a currency union. This paper contributes to the literature by quantifying reactions of European Monetary Union (EMU) stock markets to the unexpected component of monetary policy decisions of the European Central Bank (ECB). Thus, we provide evidence for the first part of the stock market channel, which captures how monetary impulses impact the real economy through the stock market.1 The stock market channel has become increasingly important in the euro area, especially during the last ten years as firms have raised an increasing share of capital through the stock markets and private investors have used the stock markets more actively for financial investments or retirement provisions (Beck et al., 2000 and Eurostat, 2007). The endogeneity of stock returns and the policy interest rate is taken into account by applying the identification through heteroskedasticity approach following Rigobon and Sack, 2004 and Rigobon, 2003. We apply this technique to all first wave euro area stock markets and extend the analysis by separately estimating the relationships of interest for financial and non-financial sectors as well as by conducting a series of homogeneity tests. We present new evidence about the degree to which the ECB’s monetary impulses impact EMU member states homogeneously.

This paper estimates the first part of the euro area stock market channel by exploring the short-run impact of ECB’s monetary policy shocks on euro area country’s stock markets. We do not find a homogeneous reaction within the group of all euro area countries. Splitting the group of all markets into two groups, which cover the stock markets reacting significantly to monetary policy shocks and the ones which do not, each sub-group reveals a higher degree of homogeneity. Interestingly, the group of markets, which react significantly to unexpected interest rate decisions is equal to the markets with the highest stock market capitalization. Consequently, since the same monetary impulse impacts stock markets of the member states differently, our results suggest that the first part of the stock market channel in the euro area is not operating identically in all countries. Our results are in line with previous evidence, such as Angeloni and Ehrmann, 2003 and Bohl et al., 2008. Against this background, and since stock markets are known to impact the real economy (Jansen and Nahuis, 2003 and Poterba, 2000), central bankers should consider the heterogeneity in the stock market response to monetary policy actions when assessing how future economic conditions will be reflected in stock market performance.