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Optimal monetary policy rules for the euro area: an analysis using the area wide model

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Author Info
Alistair Dieppe () (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)
Keith Küster () (Chair for Monetary Theory and Policy, Johann Wolfgang Goethe-University, Postbox 94, D-60054 Frankfurt/Main.)
Peter McAdam () (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.)

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Abstract

In this paper, we analyze optimal monetary policy rules in a model of the euro area, namely the ECB’s Area Wide Model, which embodies a high degree of intrinsic persistence and a limited role for forward-looking expectations. These features allow us, in large measure, to differentiate our results from many of those prevailing in New Keynesian paradigm models. Specifi- cally, our exercises involve analyzing the performance of various generalized Taylor rules both from the literature and optimized to the reference model. Given the features of our modelling framework, we find that optimal policy smoothing need only be relatively mild. Furthermore, there is substantial gain from implementing forecast-based as opposed to outcome-based policies with the optimal forecast horizon for inflation ranging between two and three years. Benchmarking against fully optimal policies, we further highlight that the gain of additional states in the rule may compensate for a reduction of communicability. Thus, the paper contributes to the debate on optimal monetary policy in the euro area, as well as to the conduct of monetary policy in face of substantial persistence in the transmission mechanism.

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Paper provided by European Central Bank in its series Working Paper Series with number 360.

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Length: 53 pages
Date of creation: May 2004
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Handle: RePEc:ecb:ecbwps:20040360

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Related research
Keywords: euro area; monetary policy rule; optimization.;

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Find related papers by JEL classification:
E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Dieppe, Alistair & Henry, Jerome, 2004. "The euro area viewed as a single economy: how does it respond to shocks?," Economic Modelling, Elsevier, vol. 21(5), pages 833-875, September. [Downloadable!] (restricted)
  2. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December. [Downloadable!] (restricted)
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  3. Levin, Andrew T. & Williams, John C., 2003. "Robust monetary policy with competing reference models," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 945-975, July. [Downloadable!] (restricted)
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  4. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies. [Downloadable!]
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  5. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of Simple Monetary Policy Rules under Model Uncertainty," NBER Working Papers 6570, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Jeffrey C. Fuhrer, 1995. "The [un]importance of forward-looking behavior in price specifications," Working Papers 95-6, Federal Reserve Bank of Boston. [Downloadable!]
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  7. N. Gregory Mankiw & Ricardo Reis, 2003. "What Measure of Inflation Should a Central Bank Target?," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1058-1086, 09. [Downloadable!] (restricted)
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  8. Batini, Nicoletta & Nelson, Edward, 2000. "Optimal Horizons for Inflation Targeting," Working Paper Series 103, Sveriges Riksbank (Central Bank of Sweden). [Downloadable!]
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  9. McAdam, Peter & Hughes Hallett, A J, 1999. " Nonlinearity, Computational Complexity and Macroeconomic Modelling," Journal of Economic Surveys, Blackwell Publishing, vol. 13(5), pages 577-618, December. [Downloadable!] (restricted)
  10. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary policy rules in practice," Proceedings, Federal Reserve Bank of San Francisco, issue Mar. [Downloadable!]
  11. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  12. Alistair Dieppe & Jerome Henry & Peter Mc Adam, . "Labour market dynamics in the euro area: A model-based sensitivity analysis," Modeling, Computing, and Mastering Complexity 2003 09, Society for Computational Economics. [Downloadable!]
  13. Barbara Roffia & Dieter Gerdesmeier, 2003. "A comprehensive model on the Euro overnight rate," Working Paper Series 206, European Central Bank. [Downloadable!]
  14. Gabriel Fagan & Jérôme Henry & Ricardo Mestre, 2001. "An area-wide model (AWM) for the euro area," Working Paper Series 42, European Central Bank. [Downloadable!]
  15. Nicoletta Batini & Andrew G Haldane, . "Forward-looking rules for monetary policy," Bank of England working papers 91, Bank of England. [Downloadable!]
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  16. Lubik, Thomas A. & Schorfheide, Frank, 2003. "Computing sunspot equilibria in linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 28(2), pages 273-285, November. [Downloadable!] (restricted)
  17. Frederico S. Finan & Robert Tetlow, 1999. "Optimal control of large, forward-looking models efficient solutions and two examples," Finance and Economics Discussion Series 1999-51, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  18. Richard Dennis, 2001. "Optimal policy in rational-expectations models: new solution algorithms," Working Papers in Applied Economic Theory 2001-09, Federal Reserve Bank of San Francisco. [Downloadable!]
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  19. Anderson, Gary & Moore, George, 1985. "A linear algebraic procedure for solving linear perfect foresight models," Economics Letters, Elsevier, vol. 17(3), pages 247-252. [Downloadable!] (restricted)
  20. Alex Cukierman, 1989. "Why does the Fed smooth interest rates?," Proceedings, Federal Reserve Bank of St. Louis, pages 111-157.
  21. Gerlach, Stefan & Schnabel, Gert, 2000. "The Taylor rule and interest rates in the EMU area," Economics Letters, Elsevier, vol. 67(2), pages 165-171, May. [Downloadable!] (restricted)
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. 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. [Downloadable!]
    Other versions:
  2. George Hondroyiannis & Sophia Lazaretou, 2004. "Inflation persistence during periods of structural change - an assessment using Greek data," Working Paper Series 370, European Central Bank. [Downloadable!]
    Other versions:
  3. Andrew Hughes Hallett, 2004. "Post-Thatcher Fiscal Strategies in the U.K.: An Interpretation," CESifo Working Paper Series CESifo Working Paper No. , CESifo Group Munich. [Downloadable!]
  4. Ramón Adalid & Günter Coenen & Peter McAdam & Stefano Siviero, 2005. "The Performance and Robustness of Interest-Rate Rules in Models of the Euro Area," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May. [Downloadable!]
    Other versions:
  5. Thorsten V. Koeppl & Cyril Monnet, 2004. "Guess what: it's the settlements!," Working Paper Series 375, European Central Bank. [Downloadable!]
    Other versions:
  6. Küster, Keith & Wieland, Volker, 2005. "Insurance Policies for Monetary Policy in the Euro Area," CEPR Discussion Papers 4956, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  7. Bernhard Herz & Werner Roeger & Lukas Vogel, . "Optimal Simple Rules for Fiscal Policy in a Monetary Union," Macroeconomics, Department of Economics, Economics I, Bayreuth University. [Downloadable!]
    Other versions:
  8. Paul Levine & Peter McAdam & Joseph Pearlman, 2007. "Quantifying and sustaining welfare gains from monetary commitment," Working Paper Series 709, European Central Bank. [Downloadable!]
    Other versions:
  9. Hughes Hallett, Andrew, 2005. "In Praise of Fiscal Restraint and Debt Rules. What the Euro Zone Might Do Now," CEPR Discussion Papers 5043, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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