Welfare-theoretic Optimal Policies in a New-Keynesian Economy with Heterogeneous Regions: Any Role for Financial Integration?

This paper provides a welfare-theoretic explanation of the inferiority of area-wide policies, com- pared to their country-specific equivalents, in the case when shocks spread unevenly across regions. Our analysis points out that under union-wide policies, regions which suffer relatively more from shocks will benefit from policy interventions at the expense of others. Using the new-Keynesian framework we propose a new area-wide welfare-theoretic loss function which is heterogeneity-consistent, i.e. it guarantees the same outcomes as if a policy maker was targeting each of the regions individually. We study the dynamics of the theoretically-induced losses resulting from the area-wide policies using the example of the euro zone in the years 1999-2013 and compare it with the level of money market integration. Our study suggests that more intense financial integration was associated with smaller long-run average losses from heterogeneity-inconsistent aggregate policies. We find no similar effects for short-run dynamics.