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The Maastricht convergence criteria and optimal monetary policy for the EMU accession countries

Lipinska, Anna (2007) The Maastricht convergence criteria and optimal monetary policy for the EMU accession countries. CEPDP, 808. Centre for Economic Performance, London School of Economics and Political Science, London, UK. ISBN 9780853280149

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Identification Number: 808

Abstract

The EMU accession countries are obliged to fulfill the Maastricht convergence criteria prior to entering the EMU. What should be the optimal monetary policy satisfying these criteria? To answer this question, the paper proposes a DSGE model of a two-sector small open economy. First, I derive the micro founded loss function that represents the objective function of the optimal monetary policy not constrained to satisfy the criteria. I find that the optimal monetary policy should not only target inflation rates in the domestic sectors and aggregate output fluctuations but also domestic and international terms of trade. Second, I show how the loss function changes when the monetary policy is constrained to satisfy the Maastricht criteria. The loss function of such a constrained policy is characterized by additional elements penalizing fluctuations of the CPI inflation rate, the nominal interest rate and the nominal exchange rate around the new targets which are different from the steady state of the unconstrained optimal monetary policy. Under the chosen parameterization, the optimal monetary policy violates two criteria: concerning the CPI inflation rate and the nominal interest rate. The constrained optimal policy is characterized by a deflationary bias. This results in targeting the CPI inflation rate and the nominal interest rate that are 0.7% lower (in annual terms) than the CPI inflation rate and the nominal interest rate in the countries taken as a reference. Such a policy leads to additional welfare costs amounting to 30% of the optimal monetary policy loss.

Item Type: Monograph (Discussion Paper)
Official URL: http://cep.lse.ac.uk
Additional Information: © 2007 Anna Lipinska
Subjects: H Social Sciences > HB Economic Theory
H Social Sciences > HJ Public Finance
Sets: Collections > Economists Online
Research centres and groups > Centre for Economic Performance (CEP)
Date Deposited: 21 Jul 2008 08:52
Last Modified: 01 Oct 2010 09:12
URI: http://eprints.lse.ac.uk/id/eprint/19702

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