June 2008 issue contents
Optimal Monetary Policy in an Estimated DSGE Model of the Euro Area with Cross-Country Heterogeneity

by Eric Jondeaua and Jean-Guillaume Sahucb


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.

JEL Codes: C51, E52, F41.

Full article (PDF, 50 pages 455 kb)

a University of Lausanne and Swiss Finance Institute
b Banque de France and Audencia School of Management