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Optimal regional biases in ECB interest rate setting
European Journal of Political Economy Vol. 22 (2006) 307 – 321 www.elsevier.com/locate/ejpe
Optimal regional biases in ECB interest rate setting Ivo J.M. Arnold * Center for Finance, Universiteit Nyenrode, Straatweg 21, 3621 BG, Breukelen, The Netherlands Received 9 November 2004; received in revised form 15 August 2005; accepted 22 August 2005 Available online 24 October 2005
Abstract This paper considers whether the influence of national output and inflation rates on ECB interest rate setting should reflect a country’s weight in the eurozone economy. The findings depend on interest rate and exchange rate elasticities and openness vis-a`-vis non-eurozone countries. The major conclusion is that the ECB should respond less to inflation shocks in EMU countries that have extensive trading ties with noneurozone countries. These countries can take care of some of the monetary tightening themselves, through a real appreciation vis-a`-vis their non-eurozone trading partners. D 2005 Elsevier B.V. All rights reserved. JEL classification: E52; E58 Keywords: EMU; Taylor rule; Optimal monetary policy
1. Introduction The popularity of Taylor-type monetary policy rules (see Taylor, 1993) combined with the inception of EMU in 1999 has resulted in a growing literature on the application of Taylor rules to the eurozone: see for example Taylor (1998), Peersman and Smets (1999), Gerlach and Schnabel (2000), Faust et al. (2001), Sauer and Sturm (2003) and Fourc¸ans and Vranceanu (2004). Most studies take an aggregate perspective (as does the ECB) and aim to estimate a Taylor rule based on aggregate output and inflation data for the eurozone as a whole. The most common finding is that ECB policy can be well explained in terms of a Taylor rule. Comparisons are also made with the Bundesbank, the precursor of the ECB, for example by Smant (2002) and Hayo and Hofmann (2003).
* Tel.: +31 346 291270; fax: +31 346 291250. E-mail address: [email protected]. 0176-2680/$ - see front matter D 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.ejpoleco.2005.08.001
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Exceptions to the aggregated approach are Von Hagen and Bru¨ckner (2001), Alesina et al. (2001), Heinemann and Hu¨fner (2002) and Kool (2005). Dissatisfied with how a benchmark Taylor rule describes ECB interest rate decisions, Von Hagen and Bru¨ckner (2001) employ individual country data and report evidence suggesting that the ECB places a disproportionately high weight on economic conditions in Germany and France. Alesina et al. (2001) also argue that, in the first years of EMU, monetary policy was mostly determined by German–French preferences. These findings recently have been corroborated by Kool (2005) using a much longer sample. Heinemann and Hu¨fner (2002) also investigate whether national data add to estimates of the Taylor rule based on eurozone data, that is, whether there are regional biases in ECB policy. They report weak evidence of an influence of regional developments on ECB decision making. The search for regional biases in ECB policy is largely inspired by doubts about the governance structure of the eurosystem. The bone-country one-voteQ rule has led to the criticism that small eurozone countries are over-represented in the Governing Council of the ECB and that as a result ECB policy might be biased towards the preferences of the smaller countries (see, for example, Berger and de Haan, 2002). Evidence from the Federal Reserve Bank and the Bundesbank in Meade and Sheets (2002) and Berger and de Haan (2002) respectively indeed shows that regional economic developments may affect the voting behaviour of policymakers. Using a simple model of optimal representation in a federal central bank, Berger and Mueller (2004) find that the representation of EMU countries in the ECB council may not be optimal. In addition to this, political considerations influence the weights of member states in ECB policy. Casella (1992), for example, argues that small countries will demand a disproportionate say in the common monetary policy in return for their participation. This paper shares the disaggregate perspective on monetary policymaking with the papers cited above. There is, however, a major deviation in the line of approach. Whereas the abovementioned papers try to answer the positive question whether the ECB council is sensitive to regional developments, this paper addresses the normative question whether, from a purely economic perspective, it should respond to regional developments. I ask the question whether regional biases in ECB policy are optimal from an economic point of view. Regional biases in ECB policymaking are usually characterized as something to be avoided at all costs. The ECB cherishes its image as an impartial policymaker that considers eurozone data only, so that each member state’s contribution to the decision making process is determined by its economic weight. The ECB also emphasizes that members of its Governing Council do not represent individual countries but make decisions in the interest of the eurozone as a whole. This position is in line with the Treaty of Maastricht and shields the ECB from allegations of favouritism and embroilment in political disputes. While understandable and justifiable from a legal and political point of view, this paper challenges the economic wisdom of looking at eurozone aggregates only. I propose that, depending on the economic characteristics of regions, it may be optimal to underweight or overweight certain member states in a eurozone Taylor rule. The economic characteristics on which I focus are all related to the demand side of the economy. As we will see below, differences in output persistence, interest rate elasticities, and the differential effects of changes in the real exchange rate can give rise to regional biases. While it is not clear whether any systematic differences in output persistence and interest rate elasticities across the eurozone countries exist, Honohan and Lane (2003) emphasize that structural differences in trade orientation towards non-eurozone countries may cause differential effects of monetary policy. The empirical part of this paper focuses on this economic characteristic.
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The organization of this paper is as follows. Section 2 outlines the benchmark macro-model for two countries in a closed monetary union. In the closed model, differences in output persistence and interest elasticities may give rise to optimal regional biases in ECB policymaking. Changes in the real exchange rate have no effect. This changes in Section 3 when openness vis-a`-vis non-eurozone countries is introduced. A numerical validation in Section 4 focuses on how differences in non-eurozone trade may introduce regional biases in ECB policy and affect interest rates in the eurozone. Small, peripheral EMU countries that trade extensively with countries outside the eurozone will benefit more from the automatic macroeconomic adjustment through the real exchange rate channel than the larger EMU countries. Therefore it would make economic sense if the ECB were to tailor its interest rate policy towards the needs of the latter group of countries. Section 5 summarizes and draws some conclusions. 2. The model for the closed eurozone This section adapts the model in Romer (2001, Section 10.7) to the case of two countries in a monetary union. While the discussion below is based on Romer (2001), the model has antecedents in Svensson (1997) and Ball (1999). The model is highly stylized in lacking both micro-economic foundations and forward-looking behavior, which limits the ability to draw definitive conclusions from the analysis below. However, the model is nonetheless useful in highlighting the differences in macroeconomic adjustment across participants in a monetary union and is able to provide a theoretical rationale for the German–French bias that has been observed in monetary policy. Each national economy is modeled using two equations for aggregate demand and aggregate supply. Eqs. (1) and (2) describe aggregate demand in countries 1 and 2, identified by subscripts. The lag structure follows Romer (2001), with lagged output ( y t1, in logs) and the lagged real interest rate (r t1) entering the aggregate demand equations. This implies that monetary policy will affect output with a lag through r t1. I extend the basic model by adding the lagged change in the real exchange rate (Dq t1) to the aggregate demand equations. A positive value for Dq t1 indicates a real appreciation and reduces domestic output. In this section I view the eurozone as a closed economy, so that any changes in the real exchange rate relate only to the other country in the union. As the nominal exchange rate within a monetary union by definition equals one, Dq equals the change in the relative price ratio. The aggregate demand equations are completed by the disturbances e t,1 and e t,2, which are assumed to have mean-zero, i.i.d. distributions, yielding y1;t ¼ q1 y1;t1 b1 r1;t1 c1 Dq1;t1 þ e1;t
0bq1 b1;
b1 N0;
c1 N0;
ð1Þ
y2;t ¼ q2 y2;t1 b2 r2;t1 c2 Dq2;t1 þ e2;t
0bq2 b1;
b2 N0;
c2 N0:
ð2Þ
and
The eurozone aggregate demand function is in Eq. (3), where o-subscripts indicate GDPweighted eurozone averages of the national equivalents yo;t ¼ qo yo;t1 bo ro;t1 co Dqo;t1 þ eo;t
0bqo b1;
bo N0;
co N0:
ð3Þ
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The aggregate supply Eqs. (4) and (5) state that national inflation rates (p t,1 and p t,2) are positively related to lagged inflation and output. The supply disturbances d t,1 and d t,2 again have mean-zero, i.i.d. distributions, yielding p1;t ¼ p1;t1 þ a1 y1;t1 þ d1;t
a1 N0;
ð4Þ
p2;t ¼ p2;t1 þ a2 y2;t1 þ d2;t
a2 N0:
ð5Þ
and
Taken together, the lag structures of the supply and demand equations imply that monetary policy works with a lag and affects output before it affects inflation. In the analysis below we will focus on the effect of differences in the aggregate demand equations on ECB interest rate setting and suppress any potential differences in the supply equations. Thus we assume that increases in output will have the same effect on inflationary pressures in the eurozone, irrespective of where the output increase takes place in the union. Eqs. (4) and (5) then can be simplified to the GDP-weighted eurozone average supply Eq. in (6) po;t ¼ po;t1 þ ao yo;t1 þ do;t
ao N0:
ð6Þ
The real interest rates are defined in Eq. (7) as the uniform nominal interest rate in the eurozone (i o,t ) minus the national inflation rates, so r1;t ¼ io;t p1;t ;
and
r2;t ¼ io;t p2;t :
ð7Þ
Changes in the real exchange rate are defined as Dq1;t ¼ p1;t p2;t ;
and
Dq2;t ¼ p2;t p1;t :
ð8Þ
The closed nature of the model implies that Dq 1,t = Dq 2,t . This assumption will be dropped in the next section. The ECB sets i o,t with a view to conditions in the eurozone as a whole and dislikes variation in output and inflation. The central bank minimizes the loss * is the ECB’s function in Eq. (9), where k indicates the weight the ECB puts on inflation and yo output target h i * Þ2 þ kE p2o : ð9Þ L ¼ E ðyo yo For simplicity, in Eq. (9) the preferred level of inflation is normalized to zero. We now follow Romer’s (2001, p. 504–507) approach in solving the model. Note that the first impact of changes in i o,t is on y o,t+1 via the aggregate demand equation. Only through y o,t+1 are inflation and output in subsequent periods influenced. While the ECB cannot exactly determine the realized value of y o,t+1, it can set interest rates to manage its expectation. We assume that the ECB observes all supply and demand shocks in period t before it sets i o,t . From the eurozone aggregate demand equation in Eq. (3) then follows that ECB policy amounts to choosing qo yo;t bo ro co Dqo;t ¼ Et yo;tþ1 :
ð10Þ
Optimal policy links expected output to inflation expectations: Et yo;tþ1 ¼ gEt po;tþ1 ;
gN0:
ð11Þ
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Intuitively, the higher the inflation expectations for the next period, the more the ECB will need to cool down next period’s output and the higher g will need to be. Romer (2001) derives the following solution for the optimal value of g, denoted g*: qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi kao þ a2o k2 þ 4k : ð12Þ g¼ 2 As k increases, g* increases. In the extreme case that the central bank chooses to focus exclusively on inflation stabilization (k = l), g* simplifies to 1 / a o. It can also be shown that higher values for a o reduce g*. Thus a stronger link between inflation and output will allow for a more moderate interest rate response. Our assumption of identical aggregate supply functions across countries allows the use of Eq. (12). Differences in national aggregate demand equations will come into play when the ECB tries to hit E t [ y o,t+1] in Eq. (10) by setting the interest rate, as will be shown below. Eq. (13) follows from Eq. (11) by expressing eurozone output and inflation as weighted averages of national output and inflation, where x is the GDP-weight of country 1 ð13Þ xEt y1;tþ1 þ ð1 xÞEt y2;tþ1 ¼ g4 xEt p1;tþ1 þ ð1 xÞEt p2;tþ1 : As the eurozone economies grow at different paces, their GDP-weights will slowly change over time. Below we suppress the time subscript of N for notational convenience. Substituting Eqs. (4)–(8) in Eq. (13) yields x q1 y1;t b1 io;t p1;t c1 p1;t p2;t þ ð1 xÞ q2 y2;t b2 io;t p2;t c2 p2;t p1;t ð14Þ ¼ g4 x p1;t þ ao y1;t þ ð1 xÞ p2;t þ ao y2;t : Rearranging Eq. (14) yields the following interest rate rule io;t ¼ /1 y1;t þ /2 y2;t þ /1 p1;t þ /2 p2;t ;
ð15Þ
where /1 ¼
xðq1 þ gao Þ ; xb1 þ ð1 xÞb2
/2 ¼
ð1 xÞðq2 þ g4ao Þ ; xb1 þ ð1 xÞb2
u1 ¼
xðb1 c1 þ g4Þ þ ð1 xÞc2 ; xb1 þ ð1 xÞb2
u2 ¼
ð1 xÞðb2 c2 þ g4Þ þ xc1 : xb1 þ ð1 xÞb2
ð16Þ
Eq. (15) is a Taylor-type rule, expressing the nominal interest rate as a linear function of output and inflation in the two members of the monetary union. The coefficients in the interest rate rule depend on the values of domestic as well as foreign parameters, as Eq. (16) shows. To answer the question whether combinations of parameter values will lead to optimal regional
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biases, we will express these coefficients as a share of the sum of the coefficients across countries. Thus, for country 1 our yardsticks are / 1 / (/ 1 + / 2) and u 1 / (u 1 + u 2) for respectively shocks to output and shocks to inflation. There are two justifications to scale the coefficients in this way. First, Eq. (16) shows that parameter values for one country will also influence the coefficients for the other country. This implies that looking purely at changes in / 1 and u 1 will not tell you anything about the change in the relative weight of country 1 in interest rate policy. Second, as we will see below, for certain parameter values these yardsticks will reduce to the GDP-weight. This is a natural benchmark for assessing regional biases. In addition to using these yardsticks, the final part of the paper will address the implications of regional biases for actual interest rates. From Eq. (16), the share of the total interest rate response that can be attributed to an output shock in country 1 can be written as follows /1 xðq1 þ g4aoÞ ¼ /1 þ /2 xðq1 þ g4aoÞ þ ð1 xÞðq2 þ g4aoÞ ¼x if q1 ¼ q2 :
ð17Þ
Eq. (17) shows that the share in the interest rate response equals a country’s GDP-weight as long as the coefficients on lagged output are equal across countries (q 1 = q 2). However, if q 1 b q 2, than / 1 / (/ 1 + / 2) is smaller than x. So the ECB should respond less to demand shocks in regions where output is less persistent. Intuitively, in these regions increases in output will pose a smaller threat to future inflation than in regions where output persistence is higher. Therefore the ECB’s response can be more muted. As there are no theoretical or empirical indications that U varies systematically across EMU countries, we will not explore this issue further. Notice the absence in Eq. (17) of the interest rate elasticities. While the values of b 1 and b 2 determine the magnitudes of / 1 and / 2 (see Eq. (16)), they have no influence on their relative size. This makes intuitive sense. When demand shocks increase y 1,t and y 2,t , the ECB will have to set i o,t at a level corresponding to the average interest elasticity, as the ECB cannot target interest rate increases to specific regions within the union. Next, we let inflation shocks hit the monetary union. The share of the total interest rate response that can be attributed to country 1 now equals u1 xðb1 þ g4Þ xc1 þ ð1 xÞc2 ¼ u1 þ u2 xðb1 þ g4Þ þ ð1 xÞðb2 þ g4Þ xðb1 þ g4Þ c c0 ¼ ; if c1 ¼ 0 and c2 ¼ xðb1 þ g4Þ þ ð1 xÞðb2 þ g4Þ x ð1 xÞ c0 c0 and c2 ¼ : ¼ x; if b1 ¼ b2 ¼ bo; c1 ¼ x ð1 xÞ
ð18Þ
Eq. (18) shows this case to be more complicated than the previous one. Both the interest rate elasticity of country 1 (b 1) and the exchange rate elasticities (c 1 and c 2) now enter the numerator of Eq. (18). Recall that in the previous case, the national interest rate elasticities dropped out of Eq. (17) because of the ECB’s inability to target national real rates with a uniform nominal interest rate. However, in the presence of national shocks to inflation, cross-country differences in real interest rates can occur. Consequently, differences in interest rate elasticities may play a role in the inflation coefficients of the monetary policy rule. This works as follows. Positive inflation shocks will work to reduce real interest rates. If b 1 N b 2, the effect of the real interest
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rate reduction will be larger in country 1 than in country 2. This disproportionate effect on output will increase country 1’s share in the interest rate response, as the ECB will be concerned about its impact on future output and inflation. Therefore, if b 1 N b 2, u 1 / (u 1 + u 2) will be larger than x. Cross-country differences in interest rate elasticities may thus influence the regional weighting in a eurozone Taylor rule. We now turn to the exchange rate elasticities. The closed economy nature of the current model puts the following balance-of-payments restriction on the exchange rate elasticities
g
xc1 Dq1 þ ð1 xÞc2 Dq2 ¼ 0 Y Dq1 ¼ Dq2 ð1 xÞc2 ; or c1 ¼ x c0 c0 c1 ¼ and c2 ¼ c N0: x ð1 x Þ 0
ð19Þ
The result in Eq. (19) ensures that any change in y 1,t following a change in the real exchange rate is offset by an opposite change in y 2,t . As the changes in the real exchange rates are by definition equal and of opposite sign, this is accomplished by making the elasticities a function of size. When Eq. (19) holds, u 1 / (u 1 + u 2) is unrelated to the exchange rate elasticities, see Eq. (18). Thus, as long as we confine ourselves to a closed-economy analysis of the eurozone, real exchange rate changes inside the union are irrelevant for monetary policy. Within the context of a closed eurozone, this result can be easily understood. Any competitive advantage in one region will be completely offset by competitive disadvantages elsewhere in the monetary union. Without a net effect on eurozone output, there is no need for an interest rate response from the ECB. Below we will see that this conclusion will change once we allow for trade outside the monetary union. Finally, the last row in Eq. (18) shows that when both the balance-of-payments restriction Eq. (19) holds and the interest rate elasticities are equal (b 1 = b 2), our yardstick will again equal the GDP-weight. 3. Non-eurozone trade Clearly, the assumption that the eurozone is a closed economy is unrealistic. This section investigates whether the relaxation of this assumption matters. In the presence of trading ties with non-eurozone countries, will inflation shocks in individual EMU countries still have an effect on ECB policy proportional to their economic weight? We make the following smallcountry assumptions in the analysis below: (1) the non-eurozone area is large compared to the size of individual eurozone countries and (2) inflation shocks in these countries will neither affect the nominal exchange rate between the eurozone and outside countries, nor policymaking outside the eurozone. These small-country assumptions allow us to adapt the model in Section 2 without explicitly modeling the non-eurozone area. The introduction of non-eurozone countries changes Eq. (8) to Dq1;t ¼ p1;t h2;1 p2;t ;
Dq2;t ¼ p2;t h1;2 p1;t ;
0bh2;1 b1;
0bh1;2 b1;
ð20Þ
where h 2,1 and h 1,2 are the trade weights of respectively country 2’s share in the trade of country 1 and country 1’s share in the trade of country 2. In Eq. (20) we also assume the absence of inflation shocks outside the eurozone. Domestic inflation shocks now have a full effect on the numerator of the country’s own real exchange rate, but only a partial effect in the denominator of the other country’s real exchange rate. This partial effect is determined by the trade weights. Any
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worsening of the competitive position in country 1 following an inflation shock is now only partially offset by an improvement in the rest of the union. The remaining part of the improvement leaks to countries outside the currency union. As a result, output in the union as a whole is reduced. This may influence interest rate setting by the ECB. Using Eq. (20), the interest rate rule now becomes io;t ¼ /1 y1;t þ /2 y2;t þ u1 p1;t þ u2 p2;t ;
ð21Þ
where /1 ¼
xðq1 þ g4ao Þ ; xb1 þ ð1 xÞb2
/2 ¼
ð1 xÞðq2 þ g4ao Þ ; xb1 þ ð1 xÞb2
u1 ¼
xðb1 c1 þ g4Þ þ ð1 xÞc2 h1;2 ; xb1 þ ð1 xÞb2
u2 ¼
ð1 xÞðb2 c2 þ g4Þ þ xc1 h2;1 : xb1 þ ð1 xÞb2
ð22Þ
Eqs. (21) and (22) show that the inclusion of non-eurozone trade has no effect on / 1 and / 2 but does change u 1 and u 2. The share of the total interest rate response attributable to country 1 following an inflation shock is now u1 xðb1 þ g4Þ xc1 þ ð1 xÞc2 h1;2 ¼ u1 þ u2 xðb1 þ g4Þ xc1 þ ð1 xÞc2 h1;2 þ ð1 xÞðb2 þ g4Þ ð1 xÞc2 þ xc1 h2;1 xðb1 þ g4Þ c0 1 h1;2 c c0 ; if c1 ¼ 0 and c2 ¼ ¼ x ð1 xÞ xðb1 þ g4Þ þ ð1 xÞðb2 þ g4Þ c0 2 h2;1 h1;2 xðbo þ g4Þ c0 1 h1;2 c c0 ; if b1 ¼ b2 ¼ bo ; c1 ¼ 0 ; c2 ¼ : ¼ x ð1 xÞ ðbo þ g4Þ c0 2 h2;1 h1;2
ð23Þ
Eq. (23) shows that imposing the same simplifying assumptions regarding the interest rate and exchange rate elasticities as in the previous section no longer reduces u 1 / (u 1 + u 2) to x. Only when the trade shares are equal to one (h 1,2 = h 2,1 = 1), would Eq. (23) reduce to x. But this would bring us back to the closed eurozone case of Section 2. From looking at the final row of Eq. (23), it is hard to immediately determine when u 1 / (u 1 + u 2) is smaller or larger than x. This is because the trade shares h i, j have two opposite effects. In the denominator c 0(2 h 2,1 h1,2) works to increase u 1 / (u 1 + u 2), while in the numerator c 0(1 h1,2) works to decreases u 1 / (u 1 + u 2). The intuitive explanation runs as follows. Including non-eurozone trade, inflation shocks across the union reduce the overall amount of monetary tightening needed (this is the total effect on u 1 + u 2 in the denominator), as the real appreciation vis-a`-vis the non-eurozone area will help to depress future output and inflationary pressures. In the numerator we see this effect for country 1 separately. When country
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Table 1 Optimal regional biases
q1 N q2 b1 N b2 (1 h 1,2) N x(2h 2,1 h 1,2)
Closed eurozone model
Open eurozone model
Output coefficients
Inflation coefficients
Output coefficients
Inflation coefficients
/1 /1 þ /2
u1 u1 þ u2
/1 /1 þ /2
u1 u1 þ u2
Positive bias No bias Not applicable
No bias Positive bias Not applicable
Positive bias No bias No bias
No bias Positive bias Negative bias
1 has disproportionately high trade with non-eurozone countries, country 1’s share in the trade of country 2 (h 1,2) is relatively small and the reduction in u 1 is correspondingly larger, yielding a decrease in u 1 / (u 1 + u 2). It can be shown that this negative regional bias occurs when 1 h1;2 Nx 2 h2;1 h1;2 : ð24Þ Before turning to a numerical exercise in the next section, Table 1 recaps the results of Sections 2 and 3. It summarizes the optimal regional biases in a eurozone Taylor rule arising from cross-country differences in aggregate demand functions for both the closed and open eurozone models. Regional bias is here defined as the deviation of either / 1 / (/ 1 + / 2) or u 1 / (u 1 + u 2) from the GDP-weight x. As discussed above, differences in output persistence and interest rate elasticities yield optimal regional biases in respectively the output and inflation coefficients in a eurozone Taylor rule. This holds both in the closed and in the open eurozone model. The numerical exercise below will focus on the negative regional bias in the inflation coefficients arising from differential exposures to non-eurozone trade across EMU member states in the open eurozone model. 4. Numerical validation This section combines data on trade shares h i, j with assumptions about the other parameters in the model to arrive at first estimates of the potential optimal regional biases in ECB policy arising from differences in non-eurozone trade. I shall also assess the potential quantitative impact of the biases on interest rates. Due to the many assumptions used in the model and in setting parameter values, I emphasize that the present estimates serve more to investigate whether the theoretical effects described above could be relevant to monetary policymakers than as accurate estimates to be applied in actual monetary policymaking. We maintain the assumption made in the previous section that exchange rate elasticities depend on country size. Generalizing to the N-country case this yields ci ¼
c0 ; xi
for i ¼ 1 to N :
ð25Þ
We also generalize condition (24) to the N-country case
1
N X j¼1
! hi;j Nxi N
N X N X i¼1 j¼1
! hi; j ;
with i p j:
ð26Þ
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Table 2 The effect of non-eurozone trade on regional biases ! ! N N X N X X 1 h1; j hi; j xi N j1
Country i Belgium Germany Greece Spain France Ireland Italy Luxembourg Netherlands Austria Portugal Finland
Optimal bias in inflation coefficient
i1 j1
0.20 0.93 0.95 0.34 0.22 0.90 0.26 0.96 0.33 0.82 0.89 0.93
0.20 1.60 0.11 0.56 1.17 0.10 0.98 0.02 0.34 0.17 0.10 0.11
None Positive Negative Positive Positive Negative Positive Negative None Negative Negative Negative
Data on the trade shares h i,j have been derived for the year 2003 using the Eurostat–Comext database. Substituting trade shares and GDP-weights in Eq. (26) for all countries in the eurozone yields the results in Table 2. The first two columns list the values for respectively the left-hand and the right-hand side of Eq. (26). The final column in Table 2 indicates the direction of the optimal regional bias in u 1 / (u 1 + u 2). Table 2 can be interpreted as follows. The larger countries in the eurozone are important trading partners of most other countries in the union. This P PN works to increase Nj=1h i, j . Note that the summation runs over country j, which implies that j1h i, j can P exceed one and (1 Nj=1h i, j ) can become negative. The reverse applies to countries like Ireland and Finland whose share in other EMU countries’ trade is relatively low. The final column in Table 2 reports how the inequality in Eq. (26) works out. For the small EMU countries the inequality holds, implying that these countries should have a negative bias in u 1 / (u 1 + u 2). Thus inflation shocks in these countries should have a weight in ECB decision making lower than their GDP weight. In contrast, the four largest countries (Germany, France, Italy and Spain) should count for more than their economic weight. For Belgium and the Netherlands, the GDPweights seem to be about right. The magnitude of the regional biases is estimated using assumptions about the values of b o , g* and c 0. These are substituted into the following generalized version of Eq. (23) ! N X xi ðbo þ g4Þ c0 1 hi;j ui j¼1 !: ¼ ð27Þ N N X N X X ui ðbo þ g4Þ c0 N hi;j i¼1
i¼1 j¼1
Table 3 condenses the national estimates of the regional biases into one summary statistic: the sum of the optimal weights in Eq. (27) for the four largest eurozone countries (Germany, France Italy and Spain). Table 3 is divided into two panels, based on assumptions regarding the objectives of the ECB. Panel A assumes that the central bank focuses on inflation stabilization only, so k equals l and g* equals 1 / a o . This would probably correspond closest to the ECB’s prime responsibility to maintain a low and stable inflation rate. In panel B, we put an equal
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Table 3 Optimal weight of the four largest countries (actual weight = 0.790)
Panel A: a o = 0.1 a o = 0.5 a o = 0.75
Panel B: a o = 0.1 a o = 0.5 a o = 0.75
c 0 = 0.01
c 0 = 0.03
c 0 = 0.05
k =l b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5
0.794 0.794 0.813 0.809 0.825 0.817
0.804 0.804 0.864 0.852 0.904 0.876
0.814 0.813 0.922 0.898 0.998 0.944
k =1 b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5
0.838 0.824 0.848 0.829 0.855 0.832
0.953 0.902 0.992 0.919 1.020 0.931
1.100 0.995 1.187 1.029 1.254 1.052
Note: sum of weights of Germany, France, Italy and Spain.
weight on inflation and output stabilization (k = 1) and g* follows from substituting a o and k in Eq. (12). The values for a o – the effect of lagged output on inflation – range from a low of 0.1 to a high of 0.75. Recent panel estimates for the eurozone countries in Arnold and Verhoef (2004) suggest that a o is close to 0.20. For c 0 we have chosen values ranging from 0.01 to 0.05. For a mid-sized country like Spain (x i = 0.10) a value of 0.03 for c 0 would yield an exchange rate elasticity of 0.30. This compares to estimates of 0.15, 0.37 and 0.50 for respectively the UK, Sweden, and Switzerland in Bergvall (2002). Unfortunately, the latter paper doesn’t report estimates for eurozone countries. Finally, Table 3 reports results for two values of b o , 0.1 and 0.5. The high value corresponds to estimates in Arnold and Kool (2004), while the lower value is closer to estimates in Goodhart and Hofmann (2004). The following observations can be made from Table 3. First, the optimal overweighting of the four largest countries in a eurozone Taylor rule depends heavily on the parameter values, ranging from a negligible 0.04 (for k = l, c 0 = 0.01, a o = 0.1 and b o = 0.1) to a substantial 0.464 (for k = 1, c 0 = 0.05, a o = 0.75 and b o = 0.1). In the latter case, as well as in some other cases in Table 3, the sum of weights for the four largest economies exceeds one, implying a negative weighting for the small eurozone countries. In that case, positive inflation shocks have such a negative impact on the competitive positions of the small countries that the ECB will actually need to lower interest rates in response to this. Second, Table 3 shows that the overweighting is much stronger when the ECB aims to stabilize both output and inflation, instead of inflation only. In the latter case, the ECB responds more strongly to inflation shocks and g* is correspondingly higher, yielding higher values for u i . In Eq. (27), P the regional biases induced by differences in trading patterns then have a smaller effect on u i / u i compared to the case where g* is smaller. Lower values for a o also increase g* and thus reduce the optimal overweighting of the large countries. A similar reasoning applies to the interest elasticity, as higher values for b o again reduce the relative importance of the trade terms in Eq. (27). The intuitive explanation for all of these effects runs as follows. The imposition of uniform a’s and b’s across the eurozone implies that a growing importance of these parameters in Eq. (27) will reduce the quantitative importance of the regional biases. Regional effects are then pushed aside by the strength of the uniform parameters.
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Finally, the regional bias increases when output is more sensitive to trade, i.e. for higher values of c 0. This effect has a straightforward interpretation. When small eurozone economies are cooled down more strongly by a real appreciation vis-a`-vis non-eurozone countries, the need for monetary tightening is smaller. The ECB can then afford to pay less attention to these countries and to focus on those countries where the real exchange rate channel is less important. For reasons discussed in Section 2, up to now we have focused on the share of a country in the total interest rate response as our yardstick for regional biases. We have also seen that, depending on the parameter values, these biases range form negligible to sizable. Ultimately, however, the practical relevance of our model is determined by its ability to move interest rates. We therefore now turn to the question whether the regional biases discussed above are able to generate differences in interest rates that are empirically meaningful. This is done by defining i o,to i o,tc as the differential between the interest rate resulting from the open eurozone model in Section 3 (i o,to) and the interest rate resulting from the closed eurozone model in Section 2 (i o,tc). This interest rate differential can be written as follows ioo;t ico;t ¼
N X
uoi uci pi;t
i¼1
0
1 B C N B X xi ðbo þ g4Þ xi ðbo þ g4Þ C B Cpi;t ! ¼ B C N B bo X A i¼1 @ hi;j bo c0 1 j¼1
0 N B X B B ¼ B i¼1 @
c0 1
N X j¼1
bo
!1 hi;j
C C Cpi;t ; C A
ð28Þ
where uoi and uci refer to the inflation coefficients for respectively the open and closed model. As the output coefficients in Eq. (21) are unaffected by the inclusion of non-eurozone trade, the interest rate differential in Eq. (28) depends solely on the cross-product of (uoi uci ) and the deviations of inflation from the preferred level (p i,t ). The empirical distribution of p i,t across the EMU countries will influence the interest rate differential in two ways. Obviously, when inflation would be at the preferred level in all member states (p i,t = 0 for i = 1 to N), the difference between the inflation coefficients uoi and uci would be inconsequential and the interest rate differential would equal zero. A more interesting way in which the distribution of p i,t matters is through a potential relationship between p i,t and the size of member states. If these two variables are statistically independent, the interest rate consequences of regional biases would tend to average out. As an example, imagine the case where both Greece and Ireland would have negative regional biases but opposite inflation experiences. This may change when inflation and country size are interdependent. For example, when positive inflation deviations are concentrated in the group of small, peripheral countries, whereas the larger eurozone economies tend to have negative inflation deviations (or vice versa),
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Fig. 1. Development of the interest rate differential i oo,t i o,t .
the effect of regional biases on the interest rate differential can be much larger than in the case of statistical independence. As this is an empirical matter, we will use inflation data over the period 1999–2004 to calculate the interest rate differential. The inflation rates are annual and have been taken from the European Commission’s AMECO database. Eq. (28) shows that we need to combine these data with parameter values for the trade shares, the exchange rate elasticity and the interest rate elasticity. For the trade shares, we again use the data from the Eurostat–Comext database. For the exchange rate elasticity, we use the same range of values as above. The interest rate elasticity has been put at 0.5. As a lower value of b o would translate into a larger interest rate differential, see Eq. (28), our estimates of i o,to i o,tc are conservative. Finally note that g* drops out of Eq. (28). This implies that although parameters a o and k do influence the relative weight of a country in the combined interest rate response, see Table 3, they will not affect i oo,t i co,t . Fig. 1 plots the resulting interest rate differentials for three values of c 0. A few observations stand out. First, the exchange rate elasticity is a key parameter. The lowest value of c 0 results in an interest rate differential of at most 0.2 percentage points, whereas for the highest value of c 0 the differential is close to a full percentage point. Second, the interest rate differential is highest in the years 2000 and 2001. The inflation distribution offers an explanation for this. The years 2000 and 2001 witnessed the concentration of high inflation rates in small EMU countries that were highly open to non-eurozone trade. This especially applies to Ireland and Finland. In these two years, the correlation coefficients between p i,t and country size were respectively 0.53 and 0.44. Since 2001, the correlation coefficient has dropped to a low of 0.01 in 2004. In addition to this, the size of the inflation deviations has also decreased over the years. As a consequence, the interest rate differential is substantially lower in 2004. The model developed above seems able to explain why eurozone interest rates should have been lower than the interest rate according to a standard eurozone Taylor rule, especially for the years 2000 and 2001. During these years, high inflation shocks were concentrated in small EMU countries that were relatively open to non-eurozone trade. The order of magnitude of the interest rate differential in Fig. 1 is similar to the difference between the actual interest rate and the interest rate derived from a eurozone Taylor rule in Von Hagen and Bru¨ckner (2001), see their
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Fig. 1. It thus appears that the ECB did what it should have done from the perspective of optimal monetary policy. 5. Conclusions This paper has analyzed how differences in economic characteristics across EMU countries affect optimal weighting in a eurozone Taylor rule. To this end, Romer’s (2001) backward looking model of optimal monetary policy has been adapted to the case of two countries within a monetary union. The main economic characteristic on which the paper has focused is trade of EMU members with non-eurozone countries. Cross-country differences in trade orientation have been shown to open an alternative adjustment channel. Small and relatively open economies trade more with countries outside the eurozone area. In these countries the automatic stabilization in the form of real exchange rate changes vis-a`-vis non-euro area trading partners functions better than in the larger EMU countries. Consequently, ECB policy should focus more on inflationary developments in the latter group of countries. The conclusion of this paper may be regarded by some as politically incorrect. An optimal monetary policy in the eurozone may imply that the ECB overweights output and inflation developments in the larger member states and discounts what happens in small eurozone countries. For the legal and political reasons discussed in the introduction, the ECB may not wish to admit that it pays disproportionate attention to the economic circumstances in the larger eurozone countries. The evidence in Von Hagen and Bru¨ckner (2001), Alesina et al. (2001) and Kool (2005) suggests that this is precisely what the ECB does, although some papers (see Heinemann and Hu¨fner, 2002; Berger and Mueller, 2004) suggest the opposite. The contribution of this paper to the monetary policy debate is a theoretical rationale for the German–French bias in ECB monetary policy that has been observed in several empirical papers. Our findings show that neglecting bouts of inflation in small peripheral member states may be the optimal thing to do and should not concern policymakers. I thus provide policymakers with an economic argument with which to counter criticism of neglecting inflationary developments in the smaller member countries. There also implications for the debate on the future governance structure of the ECB (see Berger et al., 2003). The optimal regional biases developed in this paper provide an additional argument to give more voting power to the larger EMU countries. Casella (1992) notes that small and peripheral countries may not be inclined politically to accept under-representation in ECB policy decisions. The feasibility of applying the optimal regional biases derived in this paper depend on whether small countries perceive the costs of exiting EMU to be higher than the costs of under-representation. Acknowledgements This paper was presented at the NAKE Research Day on October 22, 2004 at De Nederlandsche Bank, Amsterdam. Participants’ comments are gratefully acknowledged. I also thank the referees for their useful comments and suggestions. Remaining errors are my own. References Alesina, A., Blanchard, O., Gali, J., Giavazzi, F., Uhlig, H., 2001. Defining a macroeconomic framework for the Euro area. Monitoring the ECB no. 3, CEPR, London.
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Arnold, I.J.M., Kool, C.J.M., 2004. The role of inflation differentials in regional adjustment: evidence from the United States. Kredit und Kapital 37, 62 – 85. Arnold, I.J.M., Verhoef, B., 2004. External causes of euro zone inflation differentials: a re-examination of the evidence. Intereconomics, Review of European Economic Policy 39, 54 – 63. Ball, L., 1999. Aggregate demand and long-term unemployment. Brookings Papers on Economic Activity 2, 189 – 251. Berger, H., de Haan, J., 2002. Are small countries too powerful within the ECB? Atlantic Economic Journal 30, 1 – 20. Berger, H., Mueller, T., 2004. How should large and small countries be represented in a currency union? Working Paper no. 1344, CESifo, Munich. Berger, H., de Haan, J., Inklaar, R., 2003. Restructuring the ECB. Working Paper no. 1084, CESifo, Munich. Bergvall, A., 2002. The stabilizing properties of floating exchange rates: some international evidence, Unpublished paper, Uppsala University, Uppsala. Casella, A., 1992. Participation in a currency union. American Economic Review 82, 847 – 863. Faust, J., Rogers, J., Wright, J., 2001. An empirical comparison of Bundesbank and ECB monetary policy rules. International Finance Discussion Paper no. 705. Board of Governors of the Federal Reserve System, Washington, D.C. Fourc¸ans, A., Vranceanu, R., 2004. The ECB interest rate rule under the Duisenberg presidency. European Journal of Political Economy 20, 579 – 595. Gerlach, S., Schnabel, G., 2000. The Taylor rule and interest rates in the EMU area. Economics Letters 67, 165 – 171. Goodhart, C., Hofmann, B., 2004. Monetary transmission in simple backward-looking models: the IS puzzle. Paper Presented at the 2004 Venice Summer Institute, CESifo, Munich. Hayo, B., Hofmann, B., 2003. Monetary policy reaction functions: ECB versus Bundesbank. Working Paper no. B24ZEI, Bonn. Heinemann, F., Hu¨fner, F.P., 2002. Is the view from the Eurotower purely European?: national divergence and ECB interest rate policy. ZEW Discussion Paper 02–69. Centre for European Economic Research, Mannheim. Honohan, P., Lane, P.R., 2003. Divergent inflation rates in EMU. Economic Policy 18, 357 – 394. Kool, C.J.M., 2005. What drives ECB monetary policy? Discussion Paper no. 05–03Utrecht School of Economics, Utrecht. Meade, E.E., Sheets, D.N., 2002. Regional influences on US monetary policy: some implications for Europe. International Finance Discussion Paper no. 721. Board of Governors of the Federal Reserve System, Washington. Peersman, G., Smets, F., 1999. The Taylor rule: a useful monetary policy benchmark for the Euro area? International Finance 2, 85 – 116. Romer, D., 2001. Advanced Macroeconomics. McGraw-Hill, New York. Sauer, S., Sturm, J.-E., 2003. Using Taylor rules to understand ECB monetary policy. Working Paper no. 1110, CESifo, Munich. Smant, D.J.C., 2002. Has the European Central Bank followed a Bundesbank policy? Evidence from the early years. Kredit und Kapital 35, 327 – 343. Svensson, L., 1997. Inflation forecast targeting: implementing and monitoring inflation targets. European Economic Review 41, 1111 – 1146. Von Hagen, J., Bru¨ckner, M., 2001. Monetary policy in unknown territory: the European Central Bank in the early years. Working Paper no. B18ZEI, Bonn. Taylor, J.B., 1993. Discretion versus policy rules in practice. Carnegie–Rochester Conference Series of Public Policy 39, 195 – 214. Taylor, J.B., 1998. The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European Central Bank. Working Paper no. 58. Sveriges Riksbank, Stockholm.
Optimal regional biases in ECB interest rate setting Ivo J.M. Arnold * Center for Finance, Universiteit Nyenrode, Straatweg 21, 3621 BG, Breukelen, The Netherlands Received 9 November 2004; received in revised form 15 August 2005; accepted 22 August 2005 Available online 24 October 2005
Abstract This paper considers whether the influence of national output and inflation rates on ECB interest rate setting should reflect a country’s weight in the eurozone economy. The findings depend on interest rate and exchange rate elasticities and openness vis-a`-vis non-eurozone countries. The major conclusion is that the ECB should respond less to inflation shocks in EMU countries that have extensive trading ties with noneurozone countries. These countries can take care of some of the monetary tightening themselves, through a real appreciation vis-a`-vis their non-eurozone trading partners. D 2005 Elsevier B.V. All rights reserved. JEL classification: E52; E58 Keywords: EMU; Taylor rule; Optimal monetary policy
1. Introduction The popularity of Taylor-type monetary policy rules (see Taylor, 1993) combined with the inception of EMU in 1999 has resulted in a growing literature on the application of Taylor rules to the eurozone: see for example Taylor (1998), Peersman and Smets (1999), Gerlach and Schnabel (2000), Faust et al. (2001), Sauer and Sturm (2003) and Fourc¸ans and Vranceanu (2004). Most studies take an aggregate perspective (as does the ECB) and aim to estimate a Taylor rule based on aggregate output and inflation data for the eurozone as a whole. The most common finding is that ECB policy can be well explained in terms of a Taylor rule. Comparisons are also made with the Bundesbank, the precursor of the ECB, for example by Smant (2002) and Hayo and Hofmann (2003).
* Tel.: +31 346 291270; fax: +31 346 291250. E-mail address: [email protected]. 0176-2680/$ - see front matter D 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.ejpoleco.2005.08.001
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Exceptions to the aggregated approach are Von Hagen and Bru¨ckner (2001), Alesina et al. (2001), Heinemann and Hu¨fner (2002) and Kool (2005). Dissatisfied with how a benchmark Taylor rule describes ECB interest rate decisions, Von Hagen and Bru¨ckner (2001) employ individual country data and report evidence suggesting that the ECB places a disproportionately high weight on economic conditions in Germany and France. Alesina et al. (2001) also argue that, in the first years of EMU, monetary policy was mostly determined by German–French preferences. These findings recently have been corroborated by Kool (2005) using a much longer sample. Heinemann and Hu¨fner (2002) also investigate whether national data add to estimates of the Taylor rule based on eurozone data, that is, whether there are regional biases in ECB policy. They report weak evidence of an influence of regional developments on ECB decision making. The search for regional biases in ECB policy is largely inspired by doubts about the governance structure of the eurosystem. The bone-country one-voteQ rule has led to the criticism that small eurozone countries are over-represented in the Governing Council of the ECB and that as a result ECB policy might be biased towards the preferences of the smaller countries (see, for example, Berger and de Haan, 2002). Evidence from the Federal Reserve Bank and the Bundesbank in Meade and Sheets (2002) and Berger and de Haan (2002) respectively indeed shows that regional economic developments may affect the voting behaviour of policymakers. Using a simple model of optimal representation in a federal central bank, Berger and Mueller (2004) find that the representation of EMU countries in the ECB council may not be optimal. In addition to this, political considerations influence the weights of member states in ECB policy. Casella (1992), for example, argues that small countries will demand a disproportionate say in the common monetary policy in return for their participation. This paper shares the disaggregate perspective on monetary policymaking with the papers cited above. There is, however, a major deviation in the line of approach. Whereas the abovementioned papers try to answer the positive question whether the ECB council is sensitive to regional developments, this paper addresses the normative question whether, from a purely economic perspective, it should respond to regional developments. I ask the question whether regional biases in ECB policy are optimal from an economic point of view. Regional biases in ECB policymaking are usually characterized as something to be avoided at all costs. The ECB cherishes its image as an impartial policymaker that considers eurozone data only, so that each member state’s contribution to the decision making process is determined by its economic weight. The ECB also emphasizes that members of its Governing Council do not represent individual countries but make decisions in the interest of the eurozone as a whole. This position is in line with the Treaty of Maastricht and shields the ECB from allegations of favouritism and embroilment in political disputes. While understandable and justifiable from a legal and political point of view, this paper challenges the economic wisdom of looking at eurozone aggregates only. I propose that, depending on the economic characteristics of regions, it may be optimal to underweight or overweight certain member states in a eurozone Taylor rule. The economic characteristics on which I focus are all related to the demand side of the economy. As we will see below, differences in output persistence, interest rate elasticities, and the differential effects of changes in the real exchange rate can give rise to regional biases. While it is not clear whether any systematic differences in output persistence and interest rate elasticities across the eurozone countries exist, Honohan and Lane (2003) emphasize that structural differences in trade orientation towards non-eurozone countries may cause differential effects of monetary policy. The empirical part of this paper focuses on this economic characteristic.
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The organization of this paper is as follows. Section 2 outlines the benchmark macro-model for two countries in a closed monetary union. In the closed model, differences in output persistence and interest elasticities may give rise to optimal regional biases in ECB policymaking. Changes in the real exchange rate have no effect. This changes in Section 3 when openness vis-a`-vis non-eurozone countries is introduced. A numerical validation in Section 4 focuses on how differences in non-eurozone trade may introduce regional biases in ECB policy and affect interest rates in the eurozone. Small, peripheral EMU countries that trade extensively with countries outside the eurozone will benefit more from the automatic macroeconomic adjustment through the real exchange rate channel than the larger EMU countries. Therefore it would make economic sense if the ECB were to tailor its interest rate policy towards the needs of the latter group of countries. Section 5 summarizes and draws some conclusions. 2. The model for the closed eurozone This section adapts the model in Romer (2001, Section 10.7) to the case of two countries in a monetary union. While the discussion below is based on Romer (2001), the model has antecedents in Svensson (1997) and Ball (1999). The model is highly stylized in lacking both micro-economic foundations and forward-looking behavior, which limits the ability to draw definitive conclusions from the analysis below. However, the model is nonetheless useful in highlighting the differences in macroeconomic adjustment across participants in a monetary union and is able to provide a theoretical rationale for the German–French bias that has been observed in monetary policy. Each national economy is modeled using two equations for aggregate demand and aggregate supply. Eqs. (1) and (2) describe aggregate demand in countries 1 and 2, identified by subscripts. The lag structure follows Romer (2001), with lagged output ( y t1, in logs) and the lagged real interest rate (r t1) entering the aggregate demand equations. This implies that monetary policy will affect output with a lag through r t1. I extend the basic model by adding the lagged change in the real exchange rate (Dq t1) to the aggregate demand equations. A positive value for Dq t1 indicates a real appreciation and reduces domestic output. In this section I view the eurozone as a closed economy, so that any changes in the real exchange rate relate only to the other country in the union. As the nominal exchange rate within a monetary union by definition equals one, Dq equals the change in the relative price ratio. The aggregate demand equations are completed by the disturbances e t,1 and e t,2, which are assumed to have mean-zero, i.i.d. distributions, yielding y1;t ¼ q1 y1;t1 b1 r1;t1 c1 Dq1;t1 þ e1;t
0bq1 b1;
b1 N0;
c1 N0;
ð1Þ
y2;t ¼ q2 y2;t1 b2 r2;t1 c2 Dq2;t1 þ e2;t
0bq2 b1;
b2 N0;
c2 N0:
ð2Þ
and
The eurozone aggregate demand function is in Eq. (3), where o-subscripts indicate GDPweighted eurozone averages of the national equivalents yo;t ¼ qo yo;t1 bo ro;t1 co Dqo;t1 þ eo;t
0bqo b1;
bo N0;
co N0:
ð3Þ
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The aggregate supply Eqs. (4) and (5) state that national inflation rates (p t,1 and p t,2) are positively related to lagged inflation and output. The supply disturbances d t,1 and d t,2 again have mean-zero, i.i.d. distributions, yielding p1;t ¼ p1;t1 þ a1 y1;t1 þ d1;t
a1 N0;
ð4Þ
p2;t ¼ p2;t1 þ a2 y2;t1 þ d2;t
a2 N0:
ð5Þ
and
Taken together, the lag structures of the supply and demand equations imply that monetary policy works with a lag and affects output before it affects inflation. In the analysis below we will focus on the effect of differences in the aggregate demand equations on ECB interest rate setting and suppress any potential differences in the supply equations. Thus we assume that increases in output will have the same effect on inflationary pressures in the eurozone, irrespective of where the output increase takes place in the union. Eqs. (4) and (5) then can be simplified to the GDP-weighted eurozone average supply Eq. in (6) po;t ¼ po;t1 þ ao yo;t1 þ do;t
ao N0:
ð6Þ
The real interest rates are defined in Eq. (7) as the uniform nominal interest rate in the eurozone (i o,t ) minus the national inflation rates, so r1;t ¼ io;t p1;t ;
and
r2;t ¼ io;t p2;t :
ð7Þ
Changes in the real exchange rate are defined as Dq1;t ¼ p1;t p2;t ;
and
Dq2;t ¼ p2;t p1;t :
ð8Þ
The closed nature of the model implies that Dq 1,t = Dq 2,t . This assumption will be dropped in the next section. The ECB sets i o,t with a view to conditions in the eurozone as a whole and dislikes variation in output and inflation. The central bank minimizes the loss * is the ECB’s function in Eq. (9), where k indicates the weight the ECB puts on inflation and yo output target h i * Þ2 þ kE p2o : ð9Þ L ¼ E ðyo yo For simplicity, in Eq. (9) the preferred level of inflation is normalized to zero. We now follow Romer’s (2001, p. 504–507) approach in solving the model. Note that the first impact of changes in i o,t is on y o,t+1 via the aggregate demand equation. Only through y o,t+1 are inflation and output in subsequent periods influenced. While the ECB cannot exactly determine the realized value of y o,t+1, it can set interest rates to manage its expectation. We assume that the ECB observes all supply and demand shocks in period t before it sets i o,t . From the eurozone aggregate demand equation in Eq. (3) then follows that ECB policy amounts to choosing qo yo;t bo ro co Dqo;t ¼ Et yo;tþ1 :
ð10Þ
Optimal policy links expected output to inflation expectations: Et yo;tþ1 ¼ gEt po;tþ1 ;
gN0:
ð11Þ
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Intuitively, the higher the inflation expectations for the next period, the more the ECB will need to cool down next period’s output and the higher g will need to be. Romer (2001) derives the following solution for the optimal value of g, denoted g*: qffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi kao þ a2o k2 þ 4k : ð12Þ g¼ 2 As k increases, g* increases. In the extreme case that the central bank chooses to focus exclusively on inflation stabilization (k = l), g* simplifies to 1 / a o. It can also be shown that higher values for a o reduce g*. Thus a stronger link between inflation and output will allow for a more moderate interest rate response. Our assumption of identical aggregate supply functions across countries allows the use of Eq. (12). Differences in national aggregate demand equations will come into play when the ECB tries to hit E t [ y o,t+1] in Eq. (10) by setting the interest rate, as will be shown below. Eq. (13) follows from Eq. (11) by expressing eurozone output and inflation as weighted averages of national output and inflation, where x is the GDP-weight of country 1 ð13Þ xEt y1;tþ1 þ ð1 xÞEt y2;tþ1 ¼ g4 xEt p1;tþ1 þ ð1 xÞEt p2;tþ1 : As the eurozone economies grow at different paces, their GDP-weights will slowly change over time. Below we suppress the time subscript of N for notational convenience. Substituting Eqs. (4)–(8) in Eq. (13) yields x q1 y1;t b1 io;t p1;t c1 p1;t p2;t þ ð1 xÞ q2 y2;t b2 io;t p2;t c2 p2;t p1;t ð14Þ ¼ g4 x p1;t þ ao y1;t þ ð1 xÞ p2;t þ ao y2;t : Rearranging Eq. (14) yields the following interest rate rule io;t ¼ /1 y1;t þ /2 y2;t þ /1 p1;t þ /2 p2;t ;
ð15Þ
where /1 ¼
xðq1 þ gao Þ ; xb1 þ ð1 xÞb2
/2 ¼
ð1 xÞðq2 þ g4ao Þ ; xb1 þ ð1 xÞb2
u1 ¼
xðb1 c1 þ g4Þ þ ð1 xÞc2 ; xb1 þ ð1 xÞb2
u2 ¼
ð1 xÞðb2 c2 þ g4Þ þ xc1 : xb1 þ ð1 xÞb2
ð16Þ
Eq. (15) is a Taylor-type rule, expressing the nominal interest rate as a linear function of output and inflation in the two members of the monetary union. The coefficients in the interest rate rule depend on the values of domestic as well as foreign parameters, as Eq. (16) shows. To answer the question whether combinations of parameter values will lead to optimal regional
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biases, we will express these coefficients as a share of the sum of the coefficients across countries. Thus, for country 1 our yardsticks are / 1 / (/ 1 + / 2) and u 1 / (u 1 + u 2) for respectively shocks to output and shocks to inflation. There are two justifications to scale the coefficients in this way. First, Eq. (16) shows that parameter values for one country will also influence the coefficients for the other country. This implies that looking purely at changes in / 1 and u 1 will not tell you anything about the change in the relative weight of country 1 in interest rate policy. Second, as we will see below, for certain parameter values these yardsticks will reduce to the GDP-weight. This is a natural benchmark for assessing regional biases. In addition to using these yardsticks, the final part of the paper will address the implications of regional biases for actual interest rates. From Eq. (16), the share of the total interest rate response that can be attributed to an output shock in country 1 can be written as follows /1 xðq1 þ g4aoÞ ¼ /1 þ /2 xðq1 þ g4aoÞ þ ð1 xÞðq2 þ g4aoÞ ¼x if q1 ¼ q2 :
ð17Þ
Eq. (17) shows that the share in the interest rate response equals a country’s GDP-weight as long as the coefficients on lagged output are equal across countries (q 1 = q 2). However, if q 1 b q 2, than / 1 / (/ 1 + / 2) is smaller than x. So the ECB should respond less to demand shocks in regions where output is less persistent. Intuitively, in these regions increases in output will pose a smaller threat to future inflation than in regions where output persistence is higher. Therefore the ECB’s response can be more muted. As there are no theoretical or empirical indications that U varies systematically across EMU countries, we will not explore this issue further. Notice the absence in Eq. (17) of the interest rate elasticities. While the values of b 1 and b 2 determine the magnitudes of / 1 and / 2 (see Eq. (16)), they have no influence on their relative size. This makes intuitive sense. When demand shocks increase y 1,t and y 2,t , the ECB will have to set i o,t at a level corresponding to the average interest elasticity, as the ECB cannot target interest rate increases to specific regions within the union. Next, we let inflation shocks hit the monetary union. The share of the total interest rate response that can be attributed to country 1 now equals u1 xðb1 þ g4Þ xc1 þ ð1 xÞc2 ¼ u1 þ u2 xðb1 þ g4Þ þ ð1 xÞðb2 þ g4Þ xðb1 þ g4Þ c c0 ¼ ; if c1 ¼ 0 and c2 ¼ xðb1 þ g4Þ þ ð1 xÞðb2 þ g4Þ x ð1 xÞ c0 c0 and c2 ¼ : ¼ x; if b1 ¼ b2 ¼ bo; c1 ¼ x ð1 xÞ
ð18Þ
Eq. (18) shows this case to be more complicated than the previous one. Both the interest rate elasticity of country 1 (b 1) and the exchange rate elasticities (c 1 and c 2) now enter the numerator of Eq. (18). Recall that in the previous case, the national interest rate elasticities dropped out of Eq. (17) because of the ECB’s inability to target national real rates with a uniform nominal interest rate. However, in the presence of national shocks to inflation, cross-country differences in real interest rates can occur. Consequently, differences in interest rate elasticities may play a role in the inflation coefficients of the monetary policy rule. This works as follows. Positive inflation shocks will work to reduce real interest rates. If b 1 N b 2, the effect of the real interest
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rate reduction will be larger in country 1 than in country 2. This disproportionate effect on output will increase country 1’s share in the interest rate response, as the ECB will be concerned about its impact on future output and inflation. Therefore, if b 1 N b 2, u 1 / (u 1 + u 2) will be larger than x. Cross-country differences in interest rate elasticities may thus influence the regional weighting in a eurozone Taylor rule. We now turn to the exchange rate elasticities. The closed economy nature of the current model puts the following balance-of-payments restriction on the exchange rate elasticities
g
xc1 Dq1 þ ð1 xÞc2 Dq2 ¼ 0 Y Dq1 ¼ Dq2 ð1 xÞc2 ; or c1 ¼ x c0 c0 c1 ¼ and c2 ¼ c N0: x ð1 x Þ 0
ð19Þ
The result in Eq. (19) ensures that any change in y 1,t following a change in the real exchange rate is offset by an opposite change in y 2,t . As the changes in the real exchange rates are by definition equal and of opposite sign, this is accomplished by making the elasticities a function of size. When Eq. (19) holds, u 1 / (u 1 + u 2) is unrelated to the exchange rate elasticities, see Eq. (18). Thus, as long as we confine ourselves to a closed-economy analysis of the eurozone, real exchange rate changes inside the union are irrelevant for monetary policy. Within the context of a closed eurozone, this result can be easily understood. Any competitive advantage in one region will be completely offset by competitive disadvantages elsewhere in the monetary union. Without a net effect on eurozone output, there is no need for an interest rate response from the ECB. Below we will see that this conclusion will change once we allow for trade outside the monetary union. Finally, the last row in Eq. (18) shows that when both the balance-of-payments restriction Eq. (19) holds and the interest rate elasticities are equal (b 1 = b 2), our yardstick will again equal the GDP-weight. 3. Non-eurozone trade Clearly, the assumption that the eurozone is a closed economy is unrealistic. This section investigates whether the relaxation of this assumption matters. In the presence of trading ties with non-eurozone countries, will inflation shocks in individual EMU countries still have an effect on ECB policy proportional to their economic weight? We make the following smallcountry assumptions in the analysis below: (1) the non-eurozone area is large compared to the size of individual eurozone countries and (2) inflation shocks in these countries will neither affect the nominal exchange rate between the eurozone and outside countries, nor policymaking outside the eurozone. These small-country assumptions allow us to adapt the model in Section 2 without explicitly modeling the non-eurozone area. The introduction of non-eurozone countries changes Eq. (8) to Dq1;t ¼ p1;t h2;1 p2;t ;
Dq2;t ¼ p2;t h1;2 p1;t ;
0bh2;1 b1;
0bh1;2 b1;
ð20Þ
where h 2,1 and h 1,2 are the trade weights of respectively country 2’s share in the trade of country 1 and country 1’s share in the trade of country 2. In Eq. (20) we also assume the absence of inflation shocks outside the eurozone. Domestic inflation shocks now have a full effect on the numerator of the country’s own real exchange rate, but only a partial effect in the denominator of the other country’s real exchange rate. This partial effect is determined by the trade weights. Any
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worsening of the competitive position in country 1 following an inflation shock is now only partially offset by an improvement in the rest of the union. The remaining part of the improvement leaks to countries outside the currency union. As a result, output in the union as a whole is reduced. This may influence interest rate setting by the ECB. Using Eq. (20), the interest rate rule now becomes io;t ¼ /1 y1;t þ /2 y2;t þ u1 p1;t þ u2 p2;t ;
ð21Þ
where /1 ¼
xðq1 þ g4ao Þ ; xb1 þ ð1 xÞb2
/2 ¼
ð1 xÞðq2 þ g4ao Þ ; xb1 þ ð1 xÞb2
u1 ¼
xðb1 c1 þ g4Þ þ ð1 xÞc2 h1;2 ; xb1 þ ð1 xÞb2
u2 ¼
ð1 xÞðb2 c2 þ g4Þ þ xc1 h2;1 : xb1 þ ð1 xÞb2
ð22Þ
Eqs. (21) and (22) show that the inclusion of non-eurozone trade has no effect on / 1 and / 2 but does change u 1 and u 2. The share of the total interest rate response attributable to country 1 following an inflation shock is now u1 xðb1 þ g4Þ xc1 þ ð1 xÞc2 h1;2 ¼ u1 þ u2 xðb1 þ g4Þ xc1 þ ð1 xÞc2 h1;2 þ ð1 xÞðb2 þ g4Þ ð1 xÞc2 þ xc1 h2;1 xðb1 þ g4Þ c0 1 h1;2 c c0 ; if c1 ¼ 0 and c2 ¼ ¼ x ð1 xÞ xðb1 þ g4Þ þ ð1 xÞðb2 þ g4Þ c0 2 h2;1 h1;2 xðbo þ g4Þ c0 1 h1;2 c c0 ; if b1 ¼ b2 ¼ bo ; c1 ¼ 0 ; c2 ¼ : ¼ x ð1 xÞ ðbo þ g4Þ c0 2 h2;1 h1;2
ð23Þ
Eq. (23) shows that imposing the same simplifying assumptions regarding the interest rate and exchange rate elasticities as in the previous section no longer reduces u 1 / (u 1 + u 2) to x. Only when the trade shares are equal to one (h 1,2 = h 2,1 = 1), would Eq. (23) reduce to x. But this would bring us back to the closed eurozone case of Section 2. From looking at the final row of Eq. (23), it is hard to immediately determine when u 1 / (u 1 + u 2) is smaller or larger than x. This is because the trade shares h i, j have two opposite effects. In the denominator c 0(2 h 2,1 h1,2) works to increase u 1 / (u 1 + u 2), while in the numerator c 0(1 h1,2) works to decreases u 1 / (u 1 + u 2). The intuitive explanation runs as follows. Including non-eurozone trade, inflation shocks across the union reduce the overall amount of monetary tightening needed (this is the total effect on u 1 + u 2 in the denominator), as the real appreciation vis-a`-vis the non-eurozone area will help to depress future output and inflationary pressures. In the numerator we see this effect for country 1 separately. When country
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Table 1 Optimal regional biases
q1 N q2 b1 N b2 (1 h 1,2) N x(2h 2,1 h 1,2)
Closed eurozone model
Open eurozone model
Output coefficients
Inflation coefficients
Output coefficients
Inflation coefficients
/1 /1 þ /2
u1 u1 þ u2
/1 /1 þ /2
u1 u1 þ u2
Positive bias No bias Not applicable
No bias Positive bias Not applicable
Positive bias No bias No bias
No bias Positive bias Negative bias
1 has disproportionately high trade with non-eurozone countries, country 1’s share in the trade of country 2 (h 1,2) is relatively small and the reduction in u 1 is correspondingly larger, yielding a decrease in u 1 / (u 1 + u 2). It can be shown that this negative regional bias occurs when 1 h1;2 Nx 2 h2;1 h1;2 : ð24Þ Before turning to a numerical exercise in the next section, Table 1 recaps the results of Sections 2 and 3. It summarizes the optimal regional biases in a eurozone Taylor rule arising from cross-country differences in aggregate demand functions for both the closed and open eurozone models. Regional bias is here defined as the deviation of either / 1 / (/ 1 + / 2) or u 1 / (u 1 + u 2) from the GDP-weight x. As discussed above, differences in output persistence and interest rate elasticities yield optimal regional biases in respectively the output and inflation coefficients in a eurozone Taylor rule. This holds both in the closed and in the open eurozone model. The numerical exercise below will focus on the negative regional bias in the inflation coefficients arising from differential exposures to non-eurozone trade across EMU member states in the open eurozone model. 4. Numerical validation This section combines data on trade shares h i, j with assumptions about the other parameters in the model to arrive at first estimates of the potential optimal regional biases in ECB policy arising from differences in non-eurozone trade. I shall also assess the potential quantitative impact of the biases on interest rates. Due to the many assumptions used in the model and in setting parameter values, I emphasize that the present estimates serve more to investigate whether the theoretical effects described above could be relevant to monetary policymakers than as accurate estimates to be applied in actual monetary policymaking. We maintain the assumption made in the previous section that exchange rate elasticities depend on country size. Generalizing to the N-country case this yields ci ¼
c0 ; xi
for i ¼ 1 to N :
ð25Þ
We also generalize condition (24) to the N-country case
1
N X j¼1
! hi;j Nxi N
N X N X i¼1 j¼1
! hi; j ;
with i p j:
ð26Þ
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Table 2 The effect of non-eurozone trade on regional biases ! ! N N X N X X 1 h1; j hi; j xi N j1
Country i Belgium Germany Greece Spain France Ireland Italy Luxembourg Netherlands Austria Portugal Finland
Optimal bias in inflation coefficient
i1 j1
0.20 0.93 0.95 0.34 0.22 0.90 0.26 0.96 0.33 0.82 0.89 0.93
0.20 1.60 0.11 0.56 1.17 0.10 0.98 0.02 0.34 0.17 0.10 0.11
None Positive Negative Positive Positive Negative Positive Negative None Negative Negative Negative
Data on the trade shares h i,j have been derived for the year 2003 using the Eurostat–Comext database. Substituting trade shares and GDP-weights in Eq. (26) for all countries in the eurozone yields the results in Table 2. The first two columns list the values for respectively the left-hand and the right-hand side of Eq. (26). The final column in Table 2 indicates the direction of the optimal regional bias in u 1 / (u 1 + u 2). Table 2 can be interpreted as follows. The larger countries in the eurozone are important trading partners of most other countries in the union. This P PN works to increase Nj=1h i, j . Note that the summation runs over country j, which implies that j1h i, j can P exceed one and (1 Nj=1h i, j ) can become negative. The reverse applies to countries like Ireland and Finland whose share in other EMU countries’ trade is relatively low. The final column in Table 2 reports how the inequality in Eq. (26) works out. For the small EMU countries the inequality holds, implying that these countries should have a negative bias in u 1 / (u 1 + u 2). Thus inflation shocks in these countries should have a weight in ECB decision making lower than their GDP weight. In contrast, the four largest countries (Germany, France, Italy and Spain) should count for more than their economic weight. For Belgium and the Netherlands, the GDPweights seem to be about right. The magnitude of the regional biases is estimated using assumptions about the values of b o , g* and c 0. These are substituted into the following generalized version of Eq. (23) ! N X xi ðbo þ g4Þ c0 1 hi;j ui j¼1 !: ¼ ð27Þ N N X N X X ui ðbo þ g4Þ c0 N hi;j i¼1
i¼1 j¼1
Table 3 condenses the national estimates of the regional biases into one summary statistic: the sum of the optimal weights in Eq. (27) for the four largest eurozone countries (Germany, France Italy and Spain). Table 3 is divided into two panels, based on assumptions regarding the objectives of the ECB. Panel A assumes that the central bank focuses on inflation stabilization only, so k equals l and g* equals 1 / a o . This would probably correspond closest to the ECB’s prime responsibility to maintain a low and stable inflation rate. In panel B, we put an equal
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Table 3 Optimal weight of the four largest countries (actual weight = 0.790)
Panel A: a o = 0.1 a o = 0.5 a o = 0.75
Panel B: a o = 0.1 a o = 0.5 a o = 0.75
c 0 = 0.01
c 0 = 0.03
c 0 = 0.05
k =l b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5
0.794 0.794 0.813 0.809 0.825 0.817
0.804 0.804 0.864 0.852 0.904 0.876
0.814 0.813 0.922 0.898 0.998 0.944
k =1 b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5 b o = 0.1 b o = 0.5
0.838 0.824 0.848 0.829 0.855 0.832
0.953 0.902 0.992 0.919 1.020 0.931
1.100 0.995 1.187 1.029 1.254 1.052
Note: sum of weights of Germany, France, Italy and Spain.
weight on inflation and output stabilization (k = 1) and g* follows from substituting a o and k in Eq. (12). The values for a o – the effect of lagged output on inflation – range from a low of 0.1 to a high of 0.75. Recent panel estimates for the eurozone countries in Arnold and Verhoef (2004) suggest that a o is close to 0.20. For c 0 we have chosen values ranging from 0.01 to 0.05. For a mid-sized country like Spain (x i = 0.10) a value of 0.03 for c 0 would yield an exchange rate elasticity of 0.30. This compares to estimates of 0.15, 0.37 and 0.50 for respectively the UK, Sweden, and Switzerland in Bergvall (2002). Unfortunately, the latter paper doesn’t report estimates for eurozone countries. Finally, Table 3 reports results for two values of b o , 0.1 and 0.5. The high value corresponds to estimates in Arnold and Kool (2004), while the lower value is closer to estimates in Goodhart and Hofmann (2004). The following observations can be made from Table 3. First, the optimal overweighting of the four largest countries in a eurozone Taylor rule depends heavily on the parameter values, ranging from a negligible 0.04 (for k = l, c 0 = 0.01, a o = 0.1 and b o = 0.1) to a substantial 0.464 (for k = 1, c 0 = 0.05, a o = 0.75 and b o = 0.1). In the latter case, as well as in some other cases in Table 3, the sum of weights for the four largest economies exceeds one, implying a negative weighting for the small eurozone countries. In that case, positive inflation shocks have such a negative impact on the competitive positions of the small countries that the ECB will actually need to lower interest rates in response to this. Second, Table 3 shows that the overweighting is much stronger when the ECB aims to stabilize both output and inflation, instead of inflation only. In the latter case, the ECB responds more strongly to inflation shocks and g* is correspondingly higher, yielding higher values for u i . In Eq. (27), P the regional biases induced by differences in trading patterns then have a smaller effect on u i / u i compared to the case where g* is smaller. Lower values for a o also increase g* and thus reduce the optimal overweighting of the large countries. A similar reasoning applies to the interest elasticity, as higher values for b o again reduce the relative importance of the trade terms in Eq. (27). The intuitive explanation for all of these effects runs as follows. The imposition of uniform a’s and b’s across the eurozone implies that a growing importance of these parameters in Eq. (27) will reduce the quantitative importance of the regional biases. Regional effects are then pushed aside by the strength of the uniform parameters.
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Finally, the regional bias increases when output is more sensitive to trade, i.e. for higher values of c 0. This effect has a straightforward interpretation. When small eurozone economies are cooled down more strongly by a real appreciation vis-a`-vis non-eurozone countries, the need for monetary tightening is smaller. The ECB can then afford to pay less attention to these countries and to focus on those countries where the real exchange rate channel is less important. For reasons discussed in Section 2, up to now we have focused on the share of a country in the total interest rate response as our yardstick for regional biases. We have also seen that, depending on the parameter values, these biases range form negligible to sizable. Ultimately, however, the practical relevance of our model is determined by its ability to move interest rates. We therefore now turn to the question whether the regional biases discussed above are able to generate differences in interest rates that are empirically meaningful. This is done by defining i o,to i o,tc as the differential between the interest rate resulting from the open eurozone model in Section 3 (i o,to) and the interest rate resulting from the closed eurozone model in Section 2 (i o,tc). This interest rate differential can be written as follows ioo;t ico;t ¼
N X
uoi uci pi;t
i¼1
0
1 B C N B X xi ðbo þ g4Þ xi ðbo þ g4Þ C B Cpi;t ! ¼ B C N B bo X A i¼1 @ hi;j bo c0 1 j¼1
0 N B X B B ¼ B i¼1 @
c0 1
N X j¼1
bo
!1 hi;j
C C Cpi;t ; C A
ð28Þ
where uoi and uci refer to the inflation coefficients for respectively the open and closed model. As the output coefficients in Eq. (21) are unaffected by the inclusion of non-eurozone trade, the interest rate differential in Eq. (28) depends solely on the cross-product of (uoi uci ) and the deviations of inflation from the preferred level (p i,t ). The empirical distribution of p i,t across the EMU countries will influence the interest rate differential in two ways. Obviously, when inflation would be at the preferred level in all member states (p i,t = 0 for i = 1 to N), the difference between the inflation coefficients uoi and uci would be inconsequential and the interest rate differential would equal zero. A more interesting way in which the distribution of p i,t matters is through a potential relationship between p i,t and the size of member states. If these two variables are statistically independent, the interest rate consequences of regional biases would tend to average out. As an example, imagine the case where both Greece and Ireland would have negative regional biases but opposite inflation experiences. This may change when inflation and country size are interdependent. For example, when positive inflation deviations are concentrated in the group of small, peripheral countries, whereas the larger eurozone economies tend to have negative inflation deviations (or vice versa),
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Fig. 1. Development of the interest rate differential i oo,t i o,t .
the effect of regional biases on the interest rate differential can be much larger than in the case of statistical independence. As this is an empirical matter, we will use inflation data over the period 1999–2004 to calculate the interest rate differential. The inflation rates are annual and have been taken from the European Commission’s AMECO database. Eq. (28) shows that we need to combine these data with parameter values for the trade shares, the exchange rate elasticity and the interest rate elasticity. For the trade shares, we again use the data from the Eurostat–Comext database. For the exchange rate elasticity, we use the same range of values as above. The interest rate elasticity has been put at 0.5. As a lower value of b o would translate into a larger interest rate differential, see Eq. (28), our estimates of i o,to i o,tc are conservative. Finally note that g* drops out of Eq. (28). This implies that although parameters a o and k do influence the relative weight of a country in the combined interest rate response, see Table 3, they will not affect i oo,t i co,t . Fig. 1 plots the resulting interest rate differentials for three values of c 0. A few observations stand out. First, the exchange rate elasticity is a key parameter. The lowest value of c 0 results in an interest rate differential of at most 0.2 percentage points, whereas for the highest value of c 0 the differential is close to a full percentage point. Second, the interest rate differential is highest in the years 2000 and 2001. The inflation distribution offers an explanation for this. The years 2000 and 2001 witnessed the concentration of high inflation rates in small EMU countries that were highly open to non-eurozone trade. This especially applies to Ireland and Finland. In these two years, the correlation coefficients between p i,t and country size were respectively 0.53 and 0.44. Since 2001, the correlation coefficient has dropped to a low of 0.01 in 2004. In addition to this, the size of the inflation deviations has also decreased over the years. As a consequence, the interest rate differential is substantially lower in 2004. The model developed above seems able to explain why eurozone interest rates should have been lower than the interest rate according to a standard eurozone Taylor rule, especially for the years 2000 and 2001. During these years, high inflation shocks were concentrated in small EMU countries that were relatively open to non-eurozone trade. The order of magnitude of the interest rate differential in Fig. 1 is similar to the difference between the actual interest rate and the interest rate derived from a eurozone Taylor rule in Von Hagen and Bru¨ckner (2001), see their
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Fig. 1. It thus appears that the ECB did what it should have done from the perspective of optimal monetary policy. 5. Conclusions This paper has analyzed how differences in economic characteristics across EMU countries affect optimal weighting in a eurozone Taylor rule. To this end, Romer’s (2001) backward looking model of optimal monetary policy has been adapted to the case of two countries within a monetary union. The main economic characteristic on which the paper has focused is trade of EMU members with non-eurozone countries. Cross-country differences in trade orientation have been shown to open an alternative adjustment channel. Small and relatively open economies trade more with countries outside the eurozone area. In these countries the automatic stabilization in the form of real exchange rate changes vis-a`-vis non-euro area trading partners functions better than in the larger EMU countries. Consequently, ECB policy should focus more on inflationary developments in the latter group of countries. The conclusion of this paper may be regarded by some as politically incorrect. An optimal monetary policy in the eurozone may imply that the ECB overweights output and inflation developments in the larger member states and discounts what happens in small eurozone countries. For the legal and political reasons discussed in the introduction, the ECB may not wish to admit that it pays disproportionate attention to the economic circumstances in the larger eurozone countries. The evidence in Von Hagen and Bru¨ckner (2001), Alesina et al. (2001) and Kool (2005) suggests that this is precisely what the ECB does, although some papers (see Heinemann and Hu¨fner, 2002; Berger and Mueller, 2004) suggest the opposite. The contribution of this paper to the monetary policy debate is a theoretical rationale for the German–French bias in ECB monetary policy that has been observed in several empirical papers. Our findings show that neglecting bouts of inflation in small peripheral member states may be the optimal thing to do and should not concern policymakers. I thus provide policymakers with an economic argument with which to counter criticism of neglecting inflationary developments in the smaller member countries. There also implications for the debate on the future governance structure of the ECB (see Berger et al., 2003). The optimal regional biases developed in this paper provide an additional argument to give more voting power to the larger EMU countries. Casella (1992) notes that small and peripheral countries may not be inclined politically to accept under-representation in ECB policy decisions. The feasibility of applying the optimal regional biases derived in this paper depend on whether small countries perceive the costs of exiting EMU to be higher than the costs of under-representation. Acknowledgements This paper was presented at the NAKE Research Day on October 22, 2004 at De Nederlandsche Bank, Amsterdam. Participants’ comments are gratefully acknowledged. I also thank the referees for their useful comments and suggestions. Remaining errors are my own. References Alesina, A., Blanchard, O., Gali, J., Giavazzi, F., Uhlig, H., 2001. Defining a macroeconomic framework for the Euro area. Monitoring the ECB no. 3, CEPR, London.
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