Forecasting, Monetary Policy, Nominal Gross Domestic Product Stability, and Macroeconomic Outcomes in a suboptimal currency area. : An examination of the Eurozone

Abstract: The purpose of this paper is the examination of whether a strategy of using forecasts to stabilise the Nominal Gross Domestic Product (NGDP) growth rate as a nominal anchor, through a rules-based approach to monetary policy is viable in the Eurozone. The paper uses a modified Taylor rule, that uses NGDP forecasts as a variable to generate a prescribed interest rate from which the interest rate set by the European Central Bank (ECB) is subtracted to create a variable we call the Rate Gap. The Rate Gap is a measure of deviation that actual monetary policy had from a country’s optimal rate at a given moment in time according to the Taylor rule.  Under the hypothesis that a strategy of using forecasts to stabilise the NGDP growth rate as a nominal anchor is viable, we should expect to see countries with larger positive (negative) rate gaps have macroeconomic outcomes associated with monetary contraction (expansion). The empirical results in this paper contradict the former hypothesis as different countries have dissimilar rate gaps at the same time period which is affirmation of the Eurozone being a suboptimal currency area. However, they are supportive of the latter hypothesis, as countries with larger positive (negative) rate gaps tended to have macroeconomic outcomes associated with monetary contraction (expansion). This paper also discusses the impact of different monetary transmission mechanisms and their relationship to fiscal policy. It also contributes to the field of macroeconomics through its examination of the problem of finding viable policy strategies for a suboptimal currency area.