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Optimal Monetary Policy in the Euro Area in the Presence of Heterogeneity

Sophocles Brissimis () and Ifigeneia Skotida ()
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Ifigeneia Skotida: Bank of Greece and Athens University of Economics and Business

No 62, Working Papers from Bank of Greece

Abstract: This paper examines the optimal design of monetary policy in the European monetary union in the presence of structural asymmetries across union member countries. It derives analytically an optimal interest rate rule under commitment and studies the dependence of its coefficients on the parameters of the structural model of each economy, the central bank's preferences for inflation and output stabilization as shown in its loss function, and the relative size of each country. Based on a twocountry, forward-looking, general equilibrium model, which is estimated for two euro area countries (Germany and France), we show that there are gains to be achieved by the ECB taking into account the heterogeneity of economic structures. This finding appears to be robust under alternative weights given by the central bank to the stabilization of the target variables. Although the implementation of the proposed rule involves difficulties relating to data and estimation constraints as well as risks of accommodating structural divergences, it is important that the ECB takes into consideration national characteristics in formulating its monetary policy, especially in view of more countries joining the European monetary union in the future. However, as monetary and financial integration advances, the welfare benefits of monetary policy responding to individual countries' variables may become less significant.

Keywords: Monetary policy rules; Heterogeneous monetary union (search for similar items in EconPapers)
JEL-codes: E52 E58 (search for similar items in EconPapers)
Pages: 32 pages
Date: 2007-11
New Economics Papers: this item is included in nep-cba, nep-eec, nep-mac and nep-mon
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Journal Article: Optimal monetary policy in the euro area in the presence of heterogeneity (2008) Downloads
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