Macroeconomic Policy Design for Monetary Unions
Research Training Network
Summary
EMU is an experiment without precedent. It presents European policy-makers with formidable challenges and the research community with fascinating and little understood analytical puzzles. The proposed network aims to provide a rigorous account of the operation of macroeconomic policy in Europe, both within the euro area and in its periphery. The project will build on the latest developments in macroeconomics to assess:
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the desirability of alternative monetary policy strategies for the ECB.
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the need for coordination between monetary and fiscal authorities (and/or among the fiscal authorities themselves) within EMU.
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the desirability of alternative monetary and exchange rate arrangements for neighbouring European countries which are not members of EMU.
Recent macroeconomic research has introduced imperfect competition and nominal rigidities into models based on a dynamic stochastic general equilibrium framework. In these models, monetary policy is found to be a potential stabilization tool, but also an independent source of economic fluctuations. The study of the properties of alternative monetary policy rules (how the central bank changes the settings of its instrument in response to changes in macroeconomic conditions) has been a fruitful area of research in recent years and a natural application of the new generation of models.
The proposed network will extend this promising new line of research to the modelling of a large monetary union, made up of several economies subject to idiosyncratic shocks and with independent fiscal policies. Our objective is to develop tractable dynamic general equilibrium models that incorporate some of the key features found in the recent literature, including the existence of staggered price and wage setting by optimising, forward-looking firms and workers. General equilibrium models have become the standard procedure to allow for interactions among optimizing agents. Dynamic aspects are paramount since monetary policy largely works through expectations. An additional topic is the incorporation of prices of identical goods that differ across national borders. This is important as the ‘border effect’ has been found to be large when currencies differ and is suspected of being smaller within currency areas. The project also aims to confront the theory with the data, in order to both validate the research and interpret the current debates surrounding the single monetary policy in Europe. This constitutes a difficult and challenging research agenda, but the network, which includes some of Europe’s leading specialists in macroeconomic theory, is well placed to achieve its objectives.
The network will not only advance the frontiers of knowledge in this field, it will also provide valuable insights for European policy-makers. In particular, it will help them address two key questions:
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How to operate an effective single monetary policy in the presence of country-level idiosyncratic shocks and independent fiscal policies.
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How the ‘small’ European economies currently outside of EMU (the UK, Sweden, Switzerland, the CEECs) should make critical decisions in the next few years regarding their monetary and exchange rate arrangements, including the possibility of joining EMU.
This is a timely moment to launch this programme. The proposed network will strengthen European research capacity in this exciting new field. By extending the frontiers of research, it will make the new theory more relevant to the concerns of European policy-makers. It will diffuse new theoretical and empirical results to key research users in Europe, with whom members of the network already have strong links. The network’s research agenda will address four main issues, listed below. The most important results expected are: (i) the extension to a currency union of the modern analysis of optimal monetary policy so far developed for a single, closed economy; (ii) the joint treatment of a single monetary policy and several national fiscal policies in a consistent framework; (iii) the use of this framework to advance the analysis of central bank independence, accountability and transparency, and the link with a low inflation objective.
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Summary