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OPTIMAL MONETARY POLICY IN THE EURO AREA
IN THE PRESENCE OF HETEROGENEITY

Sophocles N. Brissimis
Bank of Greece and University of Piraeus

Ifigeneia Skotida
Bank of Greece and Athens University of Economics and Business

ABSTRACT

This paper examines the optimal design of monetary policy in the European monetary union in the presence of structural asymmetries across union member countries. It derives analytically an optimal interest rate rule under commitment and studies the dependence of its coefficients on the parameters of the structural model of each economy, the central bank's preferences for inflation and output stabilization as shown in its loss function, and the relative size of each country. Based on a twocountry, forward-looking, general equilibrium model, which is estimated for two euro area countries (Germany and France), we show that there are gains to be achieved by the ECB taking into account the heterogeneity of economic structures. This finding appears to be robust under alternative weights given by the central bank to the stabilization of the target variables. Although the implementation of the proposed rule involves difficulties relating to data and estimation constraints as well as risks of accommodating structural divergences, it is important that the ECB takes into consideration national characteristics in formulating its monetary policy, especially in view of more countries joining the European monetary union in the future. However, as monetary and financial integration advances, the welfare benefits of monetary policy responding to individual countries' variables may become less significant.

Keywords: Monetary policy rules; Heterogeneous monetary union

JEL classification: E52; E58

Acknowledgements: We would like to thank Katrin Ullrich, Heather Gibson, Stephen Hall, George Kouretas, Nicholas Magginas, Evi Pappa and participants at the 11th International Conference on Macroeconomic Analysis and International Finance, Department of Economics, University of Crete, 24-26 May 2007, for their helpful comments and suggestions. The views expressed in this paper are solely the responsibility of the authors and do not necessarily reflect the views of the Bank of Greece.

Correspondence:

Ifigeneia Skotida
Economic Research Department,
Bank of Greece, 21 E. Venizelos Ave.,
102 50 Athens, Greece,
Tel. +30 210 3202585
Email: iskotida@bankofgreece.gr


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