Examining business cycles and optimal monetary policy in a regional DSGE model

Abstract

I construct a dynamic stochastic general equilibrium (DSGE) model consisting of geographic regions and use state level data to estimate the effects that monetary policy and financial shocks have on the four census regions of the United States. The DSGE model I use is constructed around a centralized monetary authority and financial market with regional output, labor and investment markets. I find significant heterogeneity amongst the regional structural parameters of the model, creating different business cycle dynamics for the four regions. The estimated model aligns with other economic studies that suggest that monetary shocks have a greater impact in certain geographic regions in terms of employment, inflation, wages, and consumption. Simulating the estimated model, I find that monetary policy that considers the regional variation in output and inflation can significantly lower the volatility around national output and inflation. The paper’s results suggest that regional macroeconomic conditions should be considered in monetary policy decisions.