Optimal Monetary Policy rules for the Euro area in a DSGE framework

This paper evaluates optimal monetary policy rules within the context of a dynamic stochastic general equilibrium model estimated for the Euro Area. Under assumption of an ad hoc loss function for the central bank, we compute the unconditional losses both under discretion and commitment. We compare the performance of unrestricted optimal rules to the performance of optimal simple rules. The results indicate that there are considerable gains from commitment over discretion, probably due to the stabilization bias present under discretion. The lagged variant of the Taylor type of rule that allows for interest rate inertia does relatively well in approaching the performance of the unrestricted optimal rule derived under commitment. On the other hand, simple rules expressed in terms of forecasts to next period’s inflation rate seem to perform relatively worse.