This Paper explores the issues associated with the formation and implementation of a common monetary policy using data from eight of the eleven countries that are participating in the first wave of the European Monetary Union. For purposes of comparison, we also include evidence from Denmark, the U.S. and the U.K. Our approach is to provide an estimate of the objective function that each of the national central banks has been implicitly maximizing over the past fifteen years or so. While our parameterization of the loss function is very simple, it does allow us to infer the relative weight national central banks have been placing on output and inflation variability in the formulation of their policies, as well as to estimate the slope of the inflation-output variability trade-off that is implicit in the economic structure of each of these countries.
Our results suggest that while the slopes of the variability trade-offs vary quite dramatically across countries, the objective functions are not that different. We estimate that most of the countries have weights in excess of three-quarters on inflation variability and less that one-quarter on output variability, with Belgium and France having the highest weights on inflation variability and Spain and Portugal the lowest. Our methodology can be applied to the investigation of several policy issues, such as the impact of model uncertainty and the optimal speed of response to shocks.
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