Evaluating Monetary Policy of the Euro Area with Cross-Country Heterogeneity: Evidence from a New Keynesian Model

This paper empirically investigates the optimal monetary policy design for the euro area with heterogeneous economic conditions across member countries. Based on an estimated policy reaction function within a New Keynesian macroeconomic framework, we estimate optimal monetary policy conduct with a counterfactual scenario, in which the ECB reacts to economic conditions of individual members instead of the euro area as a whole. Empirical results suggest that ECB policy rates are closer to the rates that are considered “optimal ” for the core EMU members, such as Germany and France, than for other members, particularly Spain and Luxembourg. Had the ECB reacted to the economic conditions of individual members, its policy rate would have been on average 68 basis points different from the rate that was optimal for the euro area as a whole