Recent events, such as tariff announcements, illustrate that even global shocks may feature important country-specific components. This column finds that a monetary union shapes the impact of economic uncertainty on its member countries by substantially mitigating the adverse effects of country-specific shocks. It does so by providing a nominal anchor that effectively eliminates price level risk arising from country-specific uncertainty. This finding also implies heterogeneous exposure to uncertainty can reduce the need for policy interventions at the country level, whether by the common central bank or by national fiscal policy.
The re-election of Donald Trump has led to heightened uncertainty in the global economy (Grzana and Ilzetzki 2025). The whiplash-inducing, erratic tariff announcements on and around ‘Liberation Day’ on 2 April 2025, are a perfect showcase. They triggered major turmoil in global financial markets (Benigno 2025).
However, even a global uncertainty shock such as Trump’s ‘Liberation Day’ tariff announcement does not affect all countries equally. Countries have varying exposures to international trade, especially with the US. Figure 1 illustrates, from the perspective of selected European countries, the unexpected increase in stock market volatility in April 2025 — a widely used indicator of economic uncertainty. Uncertainty in Germany, Portugal, and Slovenia surged by almost three standard deviations, an event only expected in 0.3% of all months. At the same time, the impact was less pronounced in Cyprus and Lithuania. Given that these countries share a common monetary policy within the euro area, one might be concerned that the absence of a country-specific monetary policy response could amplify the shock’s effects. Indeed, it is well established that uncertainty shocks can have particularly adverse effects when monetary policy is not responsive due to the zero lower bound (Basu and Bundick 2017). The same may hold true when the exchange rate arrangement prevents a monetary policy response at the country level.
Figure 1 Increase in stock market volatility in April 2025
In new research, we show that this conjecture is wrong (Born et al. 2025). We investigate how economic uncertainty affects euro area (EA) countries compared to countries with flexible exchange rates and find that while the impact of common uncertainty shocks is comparable in both country groups, the impact of country-specific uncertainty shocks is weaker in euro area countries, not stronger as the received wisdom would suggest.
We analyse quarterly data from 17 euro area members and 13 countries with floating exchange rates over the period 1999–2022. Using a structural Bayesian vector autoregression (BVAR), we estimate the effects of uncertainty shocks based on two measures of economic uncertainty: realised stock market volatility, following Bloom (2009), and the forecast error-based uncertainty indicator developed by Jurado et al. (2015), compiled by Comunale and Nguyen (2023) for euro area countries. Importantly, we identify both common and country-specific uncertainty shocks within the BVAR.
Figure 2 Output response to common (top) vs. country-specific (bottom) uncertainty shocks
The left panels of Figure 2 show the impulse responses: how an uncertainty shock impacts economic activity over time, measured by real GDP. In the top panel, we show the adjustment to a common uncertainty shock for countries with flexible exchange rates and for EA countries. There is no difference. In the bottom panel, we show the result for a country-specific uncertainty shock: it lowers economic activity in countries with flexible exchange rates but hardly affects economic activity in euro area countries. Considering the received wisdom, this is a surprising pattern. After all, monetary policy in the euro area cannot and does not accommodate country-specific shocks.
We explain this result in a structural two-country model of a monetary union, extending the closed-economy setup of Basu and Bundick (2017). In the model, the ‘Home’ country is small and has negligible influence on union-wide aggregates, which in turn determine the common monetary policy. ‘Foreign’ represents the larger rest of the union. Uncertainty shocks in the model widen the distribution of supply and demand shocks. The model is estimated on euro area data to match the impulse responses to common uncertainty shocks. We find that the estimated model indeed predicts weaker effects of country-specific uncertainty shocks, both compared to common shocks and to a counterfactual with floating exchange rates. We show these results in the right panels of Figure 2 above. These findings are particularly noteworthy because the impulse responses to country-specific uncertainty shocks were not targeted during the estimation of the model.
Based on counterfactuals, we establish that price level risk is key for this result. Absent a monetary union, when a country’s monetary policy targets inflation, an increase in uncertainty is associated with an increase in price level risk. We illustrate this in the left panel of Figure 3, which shows the simulated long-run distribution of the price level after a demand shock with and without heightened uncertainty. Price level risk, in turn, is detrimental to consumption and investment, as we show in the paper. In contrast, even when country-specific uncertainty goes up in a country operating within the monetary union, the long-run price level remains anchored by the union level. Long-run (relative) purchasing power parity, as in the data (Bergin et al. 2017), implies that a country’s price level must converge to the union level in the absence of a flexible exchange rate.
Figure 3 Union membership eliminates price level risk
Our research highlights a key benefit of monetary union membership: the reduction of price level risk arising from country-specific uncertainty shocks. The nominal anchor provided by the union not only eliminates the inflationary bias, as is often argued (Alesina and Barro 2002), but also shapes business cycle dynamics. This finding has policy implications: heterogeneous exposure to uncertainty may be less problematic than one might think. This reduces the need for targeted policy intervention at the country level — whether by the common central bank or by national fiscal policy. Instead, it may be sufficient to rely on the stabilising effects of a credible nominal anchor, even in troubled waters.
Source : VOXeu
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