Optimal Monetary Policy Rules for the Euro Area: An Analysis Using the Area Wide Model

55 Pages Posted: 30 Nov 2004

See all articles by Alistair Dieppe

Alistair Dieppe

World Bank

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Peter McAdam

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2004

Abstract

In this paper, we analyze optimal monetary policy rules in a model of the euro area, namely the ECB's Area Wide Model, which embodies a high degree of intrinsic persistence and a limited role for forward-looking expectations. These features allow us, in large measure, to differentiate our results from many of those prevailing in New Keynesian paradigm models. Specifically, our exercises involve analyzing the performance of various generalized Taylor rules both from the literature and optimized to the reference model. Given the features of our modelling framework, we find that optimal policy smoothing need only be relatively mild. Furthermore, there is substantial gain from implementing forecast-based as opposed to outcome-based policies with the optimal forecast horizon for inflation ranging between two and three years. Benchmarking against fully optimal policies, we further highlight that the gain of additional states in the rule may compensate for a reduction of communicability. Thus, the paper contributes to the debate on optimal monetary policy in the euro area, as well as to the conduct of monetary policy in face of substantial persistence in the transmission mechanism.

Keywords: euro area, monetary policy rule, optimization

JEL Classification: E4, E5

Suggested Citation

Dieppe, Alistair and Kuester, Keith and McAdam, Peter, Optimal Monetary Policy Rules for the Euro Area: An Analysis Using the Area Wide Model (May 2004). ECB Working Paper No. 360. Available at SSRN: https://ssrn.com/abstract=533105

Alistair Dieppe (Contact Author)

World Bank ( email )

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Washington, DC 20433
United States

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Peter McAdam

European Central Bank (ECB) ( email )

Kaiserstrasse 29
Eurotower
D-60311 Frankfurt am Main
Germany
0049 69 13440 (Phone)
0044 69 1344 6000 (Fax)

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