Optimal Monetary Policy in an Estimated DSGE Model of the Euro Area with Cross-country Heterogeneity

We investigate the implications of cross-country heterogeneity within the euro area for the design of optimal monetary policy. We build an optimizing-based multi-country model (MCM) describing the euro area in which differences between structural parameters across countries are allowed. Using Bayesian techniques, we estimate the MCM and its area-wide counterpart (AWM) and compare their empirical performances. We then question which model is the most appropriate for monetary policy purposes. We find that using an AWM induces relatively large and significant welfare losses. Our results also suggest that this is not the use of a rule based on aggregated variables that is costly in terms of welfare, but rather the use of a sub-optimal forecasting model.