Optimal Control in a Monetary Union: An Application of Dynamic Game Theory to a Macroeconomic Policy Problem

Abstract

We develop a dynamic game model to study the optimal control of the economies in a two-country monetary union under startegic interactions between macroeconomic policy-makers. In this union, goverments of participating countries pursure national golas when deciding on fiscal policies, whereas the common central bank’s monetary policy aims at union-wide objective varibles. For a symmetric demand shock, we derive numerical solutions of the central bank. The different solution concepts for this game serve as models of a conflict between naional and supra-national institutions (noncooperative Nash equilibrium) on the one hand of coordinated policy-making (cooperative Pareto solutions) on the other. we show that there is a trade-off between instruments’ and targets’ deviations from desired paths; moreover, the volatility of output and inflation increase when private agents reactmore strongly to changes in actual inflation.