Optimal Monetary Policy in an Estimated Dsge Model of the Euro Area with Cross-Country Heterogeneity
47 Pages Posted: 15 Mar 2005
Date Written: November 2007
This paper investigates the implications of cross-country heterogeneity within the euro area for the design of optimal monetary policy. We build an optimizing-based multi-country model (MCM) describing the euro area in which di¤erences between structural parameters across countries are allowed. Using Bayesian techniques, we estimate the MCM and its area-wide counterpart (AWM). We then question which model is the most appropriate for monetary policy purposes. Several results emerge. First, using an AWM induces relatively large and significant welfare losses. Second, this is not the use of a rule based on aggregated variables that is costly in terms of welfare, but rather the use of a sub-optimal forecasting model. Third, allowing for habit on consumption has important implications for the dynamics of models but taking into account di¤erence in price indexation has more drastic e¤ects on welfare losses.
Keywords: Euro area, heterogeneity, optimal monetary policy, Bayesian econometrics
JEL Classification: C51, E52, F41
Suggested Citation: Suggested Citation