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 conduct for the euro area in the presence of heterogeneous economic conditions across member states. Based on the New Keynesian monetary framework, we compare welfare losses under the assumption that the central bank conducts monetary policy using area-wide aggregate data against the alternative assumption that the central bank exploits country-specific as opposed to area-wide data. Empirical results reveal a sizable gain in stabilization performance if the European Central Bank formulates monetary policy by explicitly taking into account cross-country heterogeneity within the euro area. The estimated gain is more pronounced in a hybrid variant than in the purely forward-looking version of the New Keynesian model.