Abstract
In this paper, we apply dynamic tracking games to macroeconomic policy making in a monetary union. We use a small stylized nonlinear two-country macroeconomic model of a monetary union for analyzing the interactions between two fiscal (governments: “core” and “periphery”) and one monetary (central bank) policy makers, assuming different objective functions of these decision makers. Using the OPTGAME algorithm, we calculate numerical solutions for cooperative (Pareto optimal) and non-cooperative games (feedback Nash). We show how the policy makers react to adverse demand shocks. We investigate the consequences of three scenarios: decentralized fiscal policies controlled by independent governments (the present situation), centralized fiscal policy (a fiscal union) with an independent central bank (pure fiscal union), and a fully centralized monetary and fiscal union. For the latter two scenarios, we demonstrate the importance of different assumptions about the joint objective function corresponding to different weights for the two governments in the design of the common fiscal policy. We show that a fiscal union with weights corresponding to the number of states in each of the blocs gives better results than non-cooperative policy making. When one bloc dominates the fiscal union, decentralized policies yield lower overall losses than the pure fiscal union and the monetary and fiscal union.
Highlights
The Great Recession, the financial and economic crisis which started in the United States and spread over most of the world, was the most severe crisis since the Great Depression of the 1930s
We investigate the consequences of three scenarios: decentralized fiscal policies controlled by independent governments, centralized fiscal policy with an independent central bank, and a fully centralized monetary and fiscal union
To this end we compare the performance of the players based on three scenarios: Noncoop, Fiscalun, and Monfiscun
Summary
The Great Recession, the financial and economic crisis which started in the United States and spread over most of the world, was the most severe crisis since the Great Depression of the 1930s. The development of Greece since the first debt relief seems to corroborate this prediction Another remedy for the asymmetry of the government debt situation proposed by many European policy makers is the centralization of fiscal policies in the Euro Area, from a mechanism enforcing prudent government debt policies to the institution of a fiscal union with additional competences for the union-wide. We introduce a model of a monetary union with three decision makers: two governments (blocs), named core (bloc 1) and periphery (bloc 2), which differ with respect to their initial debt level and their preferences in the debt-output/employment trade-off, and a central bank responsible for monetary policy in the entire union. One result is that a higher degree of centralization in the institutional setting of the monetary union may but need not necessarily yield better results than non-cooperative decentralized policy making
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