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

Abstract:

In this article, we analyse the conduct of optimal monetary policy for the new euro area. The aggregate euro area economy is modelled to have relatively sluggish adjustment properties and a private sector with mainly backward-looking expectations. In this economy, we assume that the central bank searches for its best-performing monetary policy rule, e.g. for the optimal weight to give to inflation stabilization compared to that of output and for the optimal degree of forward-looking in the planning horizon. We first find that the optimal degree of gradualism in interest rate-setting needs only be relatively mild and that the central bank should incorporate new information quickly into policy-making. Second, there is substantial gain from implementing and communicating quite forward-looking policies. The optimal forecast horizon for inflation ranges around six quarters. In contrast to deliberately simple rule-based policy recommendations, fully optimal policy is a complicated response to many different economic indicators. With regard to this we find, third, that optimal policy should be based on a broad information set, even if the resulting policy framework is hard to communicate to the outside world. Thus, the article contributes to the debate on optimal monetary policy for the euro area, as well as to the conduct of monetary policy in face of substantial persistence in the transmission mechanism.