Policymakers’ Revealed Preferences and the Output–Inflation Variability Trade–off: Implications for the European System of Central Banks

This paper explores two aspects of the conduct of monetary policy under a monetary union. First, even if the preferences of policymakers over inflation and output variability are identical across member countries, differences in economic structure will mean different desired policy responses to even a common shock. Second, policymakers may be forced to make important concessions in their preferences over inflation and output variability. To examine these issues, in this paper we estimate the objective functions that the European national central banks were implicitly maximizing over the 15 or so years prior to monetary union, as well as the slopes of the inflation–output variability trade–off in each country. While the slopes of the trade–offs vary dramatically across countries, the objective functions are quite similar, with most countries having weights in excess of three–quarters on inflation variability and less than one–quarter on output variability. Our findings suggest that the concessions (in terms of preferences over output and inflation variability) that current inflation–targeting countries such as the UK and Sweden would have to make on accession to the European Monetary Union (EMU) are likely to be minimal. On the other hand, the differences in economic structure across the Eurosystem countries might make it difficult to formulate a common policy even in the face of common goals, suggesting that there may still be significant costs to joining for countries currently outside the EMU.