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

31 Pages Posted: 12 Sep 2005

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)

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Abstract

In this article, we analyse the conduct of optimal monetary policy for the new euro area. The aggregate euro area economy is modelled to have relatively sluggish adjustment properties and a private sector with mainly backward-looking expectations. In this economy, we assume that the central bank searches for its best-performing monetary policy rule, e.g. for the optimal weight to give to inflation stabilization compared to that of output and for the optimal degree of forward-looking in the planning horizon. We first find that the optimal degree of gradualism in interest rate-setting needs only be relatively mild and that the central bank should incorporate new information quickly into policy-making. Second, there is substantial gain from implementing and communicating quite forward-looking policies. The optimal forecast horizon for inflation ranges around six quarters. In contrast to deliberately simple rule-based policy recommendations, fully optimal policy is a complicated response to many different economic indicators. With regard to this we find, third, that optimal policy should be based on a broad information set, even if the resulting policy framework is hard to communicate to the outside world. Thus, the article contributes to the debate on optimal monetary policy for the euro area, as well as to the conduct of monetary policy in face of substantial persistence in the transmission mechanism.

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. Journal of Common Market Studies, Vol. 43, No. 3, pp. 507-537, September 2005, Available at SSRN: https://ssrn.com/abstract=786104

Alistair Dieppe

World Bank ( email )

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Washington, DC 20433
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Keith Kuester

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

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Peter McAdam (Contact Author)

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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