EDGE: a model of the euro area with applications to monetary policy

We ask the question: Does it matter whether expections on monetary policy are heterogeneous across agents in the economy? We tackle this issue with the aid of a dynamic general equilibrium model with nominal rigidities. The most important features of the model include consumption/saving decisions according to Blanchard's stochastic lifetimes approach; valuation of private financial wealth according to the present value of capital income; overlapping Calvo wage contracts in the labour market; and a neoclassical supply side with Cobb-Douglas technology. The model is calibrated to match the first and second moments of the publicly available euro area data. In simulation checks we find that the autocorrelation structure of the model, when subjected to stochastic shocks, also resembles that of the euro area data. Furthermore, diagnostic simulation results of the model provide intuitively appealing economic responses. In studying the effect of heterogeneity of expectations, we distinguish between central bank expectations and private sector expectations. The results show that if private sector expectations differ from central bank expectations, there will be real costs to the economy. We also show that the existence of a learning mechanism in the economy results in significantly smaller costs to the economy. And we find that random shifts interpreted as lack of transparency cause changes in private sector expectations, which generate costs in the form of higher variability in the economy. All in all, our results show that heterogeneity of expectations on monetary policy may generate economically significant costs.