Is European Monetary Policy Appropriate for the EMU Member Countries? A Counterfactual Analysis

Abstract

The creation of the European Monetary Union (EMU) is the most important event in monetary economics in the last decade. It led to at least two potentially important changes with respect to the setting of short-term interest rates in the EMU member countries. First, the European Central Bank (ECB) bases its monetary policy decisions on aggregate developments in the euro area, which may conceal diverse developments at the national level. Second, the weights on inflation and output in the ECB Taylor rule may deviate from those that were a good description of national interest rates in the pre-EMU phase. The core question of this chapter is how appropriate the actual ECB interest rate setting is for each of the member countries compared to a (hypothetical) situation where national central banks are still responsible for monetary policy. This analysis may also yield some insights into the question of whether monetary policy can be blamed for the low GDP growth rate in a number of EMU member countries, e.g. Germany or Italy.