Scientific Monographs, Bank of Finland
No E:23/2002:
EDGE: a model of the euro area with applications to monetary policy
Mika Kortelainen ()
Abstract: We ask the question: Does it matter whether expections on
monetary policy are heterogeneous across agents in the economy? We tackle
this issue with the aid of a dynamic general equilibrium model with nominal
rigidities. The most important features of the model include
consumption/saving decisions according to Blanchard's stochastic lifetimes
approach; valuation of private financial wealth according to the present
value of capital income; overlapping Calvo wage contracts in the labour
market; and a neoclassical supply side with Cobb-Douglas technology. The
model is calibrated to match the first and second moments of the publicly
available euro area data. In simulation checks we find that the
autocorrelation structure of the model, when subjected to stochastic
shocks, also resembles that of the euro area data. Furthermore, diagnostic
simulation results of the model provide intuitively appealing economic
responses. In studying the effect of heterogeneity of expectations, we
distinguish between central bank expectations and private sector
expectations. The results show that if private sector expectations differ
from central bank expectations, there will be real costs to the economy. We
also show that the existence of a learning mechanism in the economy results
in significantly smaller costs to the economy. And we find that random
shifts interpreted as lack of transparency cause changes in private sector
expectations, which generate costs in the form of higher variability in the
economy. All in all, our results show that heterogeneity of expectations on
monetary policy may generate economically significant costs.
Keywords: EDGE; rational expectations; heterogeneous expectations; learning; dynamic general equilibrium model; (follow links to similar papers)
JEL-Codes: E52; (follow links to similar papers)
169 pages, August 29, 2002
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