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Optimal Monetary Policy in an Estimated DSGE Model of the Euro Area with Cross-Country Heterogeneity

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  • Eric Jondeau

    (University of Lausanne and Swiss Finance Institute)

  • Jean-Guillaume Sahuc

    (Banque de France and Audencia School of Management)

Abstract

This paper investigates the implications of cross-country heterogeneity within the euro area for the design of optimal monetary policy. We build an optimization-based multicountry model (MCM) describing the euro area in which differences between structural parameters across countries are allowed. Using Bayesian techniques, we estimate the MCM and its areawide 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 suboptimal forecasting model. Third, allowing for habit on consumption has important implications for the dynamics of models, but taking into account differences in price indexation has more drastic effects on welfare losses.

Suggested Citation

  • Eric Jondeau & Jean-Guillaume Sahuc, 2008. "Optimal Monetary Policy in an Estimated DSGE Model of the Euro Area with Cross-Country Heterogeneity," International Journal of Central Banking, International Journal of Central Banking, vol. 4(2), pages 23-72, June.
    • Handle: RePEc:ijc:ijcjou:y:2008:q:2:a:2
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    More about this item

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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