Welfare‐Theoretic Optimal Policies in a New‐Keynesian Economy with Heterogeneous Regions: Any Role for Financial Integration?

20 Pages Posted: 14 Apr 2016

Date Written: May 2016

Abstract

This paper provides a welfare‐theoretic explanation of the inferiority of area‐wide policies, com‐ pared to their country‐specific equivalents, in the case when shocks spread unevenly across regions. Our analysis points out that under union‐wide policies, regions which suffer relatively more from shocks will benefit from policy interventions at the expense of others. Using the new‐Keynesian framework we propose a new area‐wide welfare‐theoretic loss function which is heterogeneity‐consistent, i.e. it guarantees the same outcomes as if a policy maker was targeting each of the regions individually. We study the dynamics of the theoretically‐induced losses resulting from the area‐wide policies using the example of the euro zone in the years 1999-2013 and compare it with the level of money market integration. Our study suggests that more intense financial integration was associated with smaller long‐run average losses from heterogeneity‐inconsistent aggregate policies. We find no similar effects for short‐run dynamics.

Keywords: welfare, optimal policies, asymmetric shocks, heterogeneous regions

Suggested Citation

Wolski, Marcin, Welfare‐Theoretic Optimal Policies in a New‐Keynesian Economy with Heterogeneous Regions: Any Role for Financial Integration? (May 2016). JCMS: Journal of Common Market Studies, Vol. 54, Issue 3, pp. 742-761, 2016, Available at SSRN: https://ssrn.com/abstract=2764570 or http://dx.doi.org/10.1111/jcms.12337

Marcin Wolski (Contact Author)

European Investment Bank ( email )

Luxembourg City, 2968
Luxembourg
691286623 (Phone)

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