Compatibility of the single monetary policy with macroeconomic fundamentals of the Slovak Republic

Abstract

The Slovak Republic introduced single currency – euro in 2009. Thus, from January 2009 on Slovakia does not perform its independent monetary policy but is affected by the euro area policy including common interest rates. Interbank interest rate is considered as a proxy-variable aggregating overall monetary policy setting. The objective of the paper is to evaluate compatibility of the euro area interest rates with macroeconomic situation in Slovakia. In other words, the key question is whether common interest rates respond sufficiently to inflation gap, output gap or other indicators. Reaction function is estimated via autoregressive distributed lag approach for the pre-euro period as well as euro period in Slovakia. Results demonstrate that the euro area interbank interest rates did not react sufficiently neither to Slovak inflation nor output gap. These led to extremely low inflation during last months approaching the critical point of deflation with possible catastrophic impacts on Slovak economy.