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.