What to do when stagflation returns? Monetary and fiscal policy strategies for a monetary union

Abstract

In this paper we use a small stylized nonlinear two-country macroeconomic model of a monetary union for analyzing the interactions between fiscal (governments) and monetary (common central bank) policy makers, assuming different objective functions of these decision makers. Using the OPTGAME algorithm we calculate solutions for two game strategies: one cooperative (Pareto optimal) and one noncooperative game type (the Nash game for the feedback information pattern). Applying the OPTGAME algorithm to the MUMOD1 model we show how the policy makers react to adverse supply shocks according to these solution concepts. To this end we calibrate the model and the path of the exogenous variables so as to replicate some stylized facts of Euro Area developments during the Great Recession and the following sovereign debt crisis. Next, we analyze different kinds of supply side shocks and discuss the best macroeconomic policy strategies for possible future scenarios under assumptions about strategic interactions between monetary and fiscal policy makers. The results provide some insight into the asymmetries inherent in a monetary union such as the Euro Area.