Structural Asymmetries and the Optimal Monetary Policy Instrument of the European Central Bank

Byline: Carlo Monticelli (1) Keywords: European Central Bank; asymmetry; optimal monetary policy Abstract: Although the existence of differences in economic structure across European countries is well known, their implications for the conduct of the single monetary policy in Stage Three of EMU have not yet been analyzed. This paper explores the issue on the basis of a two-country, rational-expectations, stochastic model characterized by asymmetric structural equations and a general formulation for monetary policy. Only if financial shocks are the main source of instability can heterogeneity in structures be neglected. When real shocks to aggregate demand prevail, their geographical distribution and the difference in the elasticity of aggregate supply are the key factors governing the response to structural differences. When supply shocks predominate, irrespective of their geographical distribution monetary policy should lean against the wind with more determination than if countries were identical. Differences in the transmission lag of monetary policy or some concern for growth when pursuing price stabilization reduce the size of the correction in monetary policy called for by structural asymmetries. Author Affiliation: (1) Global Markets Research, Deutsche Bank, 1 Great Winchester Street, London, EC2N 2DB, UK Article History: Registration Date: 09/10/2004