Monetary Policy Transmission and Macroeconomic Dynamics in Luxembourg: Results from a VAR Analysis

The aim of this work is to study the interactions between monetary policy, credit, house prices and the macroeconomy in Luxembourg using a VAR model with quarterly data in levels from 1986 to 2009. The results of the structural analysis provide valuable information concerning the monetary policy transmission mechanism, the interactions between credit and house prices, and the importance of foreign shocks for the behaviour of domestic variables. Some tentative explanations related to the particular economic and financial structures of the Luxembourg economy are moreover suggested to interprete this empirical evidence. More specifically, the structural analysis leads to the following conclusions: (1) In accordance with the existing VAR literature, a contractionary monetary policy shock leads to a temporary decrease in output and to a gradual decline in prices. (2) Monetary policy transmission to the real economy is relatively strong in Luxembourg, a result that could be associated with the variable interest rate structure of loans to the private sector, the high degree of openness and the preponderance of the financial services industry. (3) The response of credit and GDP following a residential property price shock provides some scope for the existence of a house price channel of monetary policy transmission in Luxembourg. (4) Finally, domestic variables respond strongly to foreign shocks, as evidenced by both the impulse response functions and the forecast error variance decomposition.