Policy implications and welfare analysis under the possibility of default for the Euro zone area

This study investigates the role of monetary and macro prudential policies in a DSGE model for the Euro zone area by incorporating financial frictions, a monopolistic banking sector and shocks on technology, productivity costs, housing demand and possibility of default, under a stable and a fragile economic environment. The model is solved, using a second order approximation methodology, to evaluate policy effectiveness and welfare analysis targeting to match European key macroeconomic variables for the period 2000–2018. The inclusion of the possibility of a default under this calibration framework, which is used to mimic a financial vulnerable environment, showed that the dynamics of the model change accordingly to the existing economic environment. The simple monetary rule is more effective in stabilizing the economy under a stable environment, whereas the macro prudential rule is more effective for financial stability under a fragile environment. Moreover, the macro prudential policy is the most important tool for optimizing welfare and reducing volatility for inflation and output.