Monetary Policy Interactions between the U.S. And the Emu

Abstract

This paper examines the monetary policy relationship between the United States and the European Monetary Union (EMU) using a large open economy model that incorporates the interactions between policy makers in the two "countries". The paper builds on and extends previous research, by Ball, Svensson, McCallum and Nelson and Rotemberg & Woodford, among others, that focused on the performance of simple policy rules in closed economies or in small open economies.

Parameters of the model are matched to data taken from the U.S. and from the EMU's 11 member countries. These parameters are then used to calculate the optimal reaction coefficients of closed and open econmy monetary policy rules under both a cooperative and a non cooperative setting. The results of the paper show that, under most policy rules, the EMU has worse macroeconomic performance. Despite the overall worse performance, the results show that the EMU can gain from using policy rules that include external variables, as well as through policy cooperation. The model also confirms that the fundamental sources of the worse performance lie in the higher inflation persistence, the greater volatility of shocks and the greater openness of the EMU economies. Since all three of these sources are likely to witness substantial change following the adoption of the single currency and the creation of the European Central Bank, the results point to a more symmetric monetary policy relationship between the U.S. and the EMU in the future.

JEL Classification: E52, E58, F41