Macroeconomic Performance and Policymakers Preferences in the Euro Area , 1972 - 2001

This essay presents estimates of the monetary policymakers' preferences of the Euro Area, using quarterly aggregate Area data for 1972-2001. The analysis is motivated by the observation that the tradeoff between the volatility of inflation and the volatility of the unemployment gap has improved, in the Euro Area, since the second half of the 80s. This research tries to evaluate the role played by the three possible sources for this improvement: (i) change in the policy regime; (ii) increased efficiency in the conduction of policy; and (iii) decrease in the exogenous supply shocks buffeting the Area. Based on the macro and policy record of the EMU member-states we put forth the hypothesis that an important part of the explanation for the volatility fall lies in the emergence of a well-identified policy regime in the Area after the mid 80s. Specifically, we test for a well-identified central bank loss function, inflation target and equilibrium real interest rate, in the Area, since 1986. We try to add four results to the ongoing research on policymakers' preferences: First, we obtain evidence on the Euro Area policymakers preferences, with a framework that simultaneously estimates the structural model of the macroeconomy and the deep preferences parameters (loss function coefficients) of the Area central bank. Second, we achieve some empirical refinement of the estimation framework, compared to the related literature on the US case, as we use a gap given by a kalman filter, which yelds two advantages. First, it is closer to the real-time data available to policymakers at each period. Second, it is estimated from a model that is consistent with the one used in this research. Third, we compare the results given by alternative methods of estimation, recently used for the US case by independent researchers. Fourth, we suggest a method for testing for asymmetry in policymakers' preferences across recessions and expansions, and apply it to the Euro Area monetary regime post-86, thus presenting an alternative view of the results of this research. AKNOWLEDGEMENTS: I am indebted to Alvaro Aguiar and Fabio Canova, for helpful theoretical and technical discussions and suggestions. I am thankful to Richard Dennis (Federal Reserve Bank of San Francisco) for sharing his Gauss code for FIML estimation of policymakers preferences, which was the basis for the code used in section 4 of this essay.