Monetary Policy in a DSGE Model for Europe

Master Thesis by Katarina Primorac
August 5, 2004

Abstract:

This paper studies the role of monetary policy in a DSGE model estimated for Europe. The interaction between inflation, output gap and monetary policy rules is analyzed within the framework of a dynamic general equilibrium model derived from optimizing behavior and rational expectations. The model follows closely the work of Smets and Wouters (2003). The main motivation is to see how the economy reacts under backward looking and forward looking Taylor type monetary policy reaction functions in order to make conclusions on which type performs better within the estimated model for the Euro area. Also, using model simulations, the conclusions on the optimality of weights assigned to the reaction function coefficients are drawn. It is illustrated that although the monetary objective can be defined narrowly in terms of inflation targeting, the central bank should take a larger set of economic variables into account in deciding on the course of its policy and commit to the rule with backward looking components satisfying the Taylor principle.