Importance of International Policy Coordination
The global economy consists of many interdependent
individual and regional economies. Expansionary or
contractionary monetary and fiscal policies in one country
most often affects economic events significantly in another
economies.
Economic events in the UK are influenced by policy
choices of the France and Germany and other European
economies and the US. To some extent also by policies in
Asia, Middle East, Africa and Latin America.
Stability and prosperity as well as economic shocks and
crises in one country have wide-ranging global impacts.
It is important to consider both domestic as well as
international aspects of opportunities and constraints while
setting an economic policy.
Macroeconomic Themes: 14
1
Some Models to Analyse International
Macroeconomic Policy
(1) Mundell-Fleming two country global economy model
(2) Policy co-ordination analysis using Pareto-Contract
diagram
(3) Canzoneri M. B. and J A Gray (1985)
(4) More recent micro-founded computable general
equilibrium model of interenational monetary policy coordination.
Macroeconomic Themes: 14
2
Analysing Interdependent Economic Policy Using
Mundell-Fleming-Dornbusch Diagram
Impact in country 2
Expansionary fiscal policy in country 1
c
i1=i1*
e
d
i2=i2*
BOP
a
LM2’
LM2
LM1 LM2
IS2 IS2’
IS1’
O
y0
IS1
y1 y2
o
y20 y22 y21
Here start with a global equilibrium in which the interest rates are same across two
Macroeconomic Themes: 14
3
Simple Open Economy and Exchange Rate
Model in Mundell-Fleming World
Small Open Economy Mundell-FlemingDornbusch type model:
Fundamentals of Long Run Exchange Rate
Purchasing power parity:
Money demand:
m d  pt  y   rt   t
2
pt  p *  et
PPP:
(3.2)
*   e  e   
r

r
UIP:
t
t t
 t 1
Eee  e
Expectation:
t 1 t 1
M *  K *Y *
p*
(3.3)
(3.4)

E p
P*

*Y *
M
K
E
KY  M *
e   m  m*    k *  k    y*  y 

Sterilisation policy:
m s  m    et  e  t 
M  KY 
p
Money demand:
(3.1)
p  EP *





(3.5)
Macroeconomic Themes: 14
4
Non-Co-operative Nash and Co-operative
Solutions of Policy Games in an
Interdependent Word
Economic Policy Games in Interdependent Economies
X
I2
Policy instrument
Of Country 1
I2’
I1’
O2
I1
B
A
C
O1
O
Policy instrument of country 2
Macroeconomic Themes: 14
5
International Monetary Policy Co-ordination
Game : Canzoneri M. B. and J A Gray (1985)
There are two countries home and foreign. Their policy
objective (utility) function includes deviation of output from the
trend x and the inflation 
2
2


2
*
*
*


u   x   ; u  x   






2


     g ;  *   *  g *
0
0
2











(2)
2
u   x    g and
0
2 
2



*
*
*
*
u  x      g 


 0




(1)
(3)
x   g   g *   q ;
1
2
3
x*   *g *   *g   *q*
1
2
3
(4)
Macroeconomic Themes: 14
6
Parametric Specifications for Beggar-ThyNeighbour, Locomotive or Prosper-Thy-Neighbour
Policies
Spill over effects of the policy of one country into another depends
upon a set of policy response parameters,1 , 2 ,3 ,1* , 2* and
* .
2
There are three potential cases of policy spillover:
*
1. Symmetric negative (beggar thy neighbour) i  i
  0 ,  0
2
3
*
2. Symmetric positive (locomotive effect) i  i
  0 ,  0
2
3
3. Asymmetric (prosper thy neighbour) 1  0 ,
  0 , *  0 ,   *  0 .
2
2
3
  0,
1
  0,
1
3
Four channels of transmission mechanism for policy spill over
(a) interest rate (b) aggregate demand output (c) wage indexation
and terms of trade (d) oil prices
Macroeconomic Themes: 14
7
Coopeative and Non-co-operative Solutions of International Monetary
Policy Game in Canzoneri M. B. and J A Gray (1985)
Nash, Stackleberg and Fixed Rule equilibria in international policy coordination game
dg
N
F
N
S
dg*
N
N*
Macroeconomic Themes: 14
8
Nash Optimal Monetary Policy for Home and
Abroad
Adaptive regime of the world economy
2


u    g   g *   q    2 ;
2
3 
 1
2 
2



u*    *g *   *g   *q*     *  g * 
2
3
 1

 0

(5)
Choice of optimal policy
u  2  g   g *   q       g   0

 1
2
3  1  0

g



   g *    q 
 1 2

1
3


 g  
(6)
 2
1
u*  2  *g *   *g   *q*     *  g *   0
 1

 0


2
3
g






  *g   *q* 
 2

3

g *   
(7)
2
*
   Macroeconomic Themes: 14
1
9
Money Supply Growth Rate under the Nash
equilibrium
g  g *
  q
1 3
0
 g  
   2   *
1 1 2
Macroeconomic Themes: 14
(8)
10
Monetary Policy Choice of Home Country
Under Stackleberg Equilibrium
x   g   g *   q
1
2
3













 *g   *q*  
3     q 
x   g    2

1
2
3
2

*



1

x 











2 
2 



   *   g    *g   *q*    q    * 
1  1
3  3 
1 
 2



2
  *
1
2
2
u  x     g  
 0













u

2 
2  



*
*
*
*
*




     g    g   q    q     
1  1
3
3 
1 
 2



2
  *
1
2







Macroeconomic Themes: 14
    g 
 0

2 (9)
11
Monetary Policy Choice of Home Country
Under Stackleberg Equilibrium


*2 
* 2 


*2 
*
*
*
* 2   

    1  1g   2 g   3 q   3q   1      1  1   3q   1 
u






  
 
   0  g   0
2
2
*
*


g






1
1




  q    2   




   2   2 
1 1 2
1
2  0
g   1 3  
     2    2     2   2 

1
1
1
(11)
2

g *  

13q    12    12  1 2    12   22   1 22  1   2 




    12   12    12   22 






0
(12)
Macroeconomic Themes: 14
12
Coordination Under the Fixed Exchange Rate
Regime
Under the fixed exchange rate rule monetary policy is the
same at home and abroadg  g * . Substituting this
condition the output function in (4)
x   g   g *   q  x      g   q .
1
2
3
2
3
 1
Substitute this in the utility function and maximise wrt
g
2 
2



u       g   q      g 
2
3 
 0

 1
u      g   q  2   g   0



3 
 0

g  1 2 


      q
g   1 2  3
(13)
2
      
2
 1
Macroeconomic Themes: 14
13
Contribution of Canzonery and Gray Model in
International Policy Analysis
The major contribution of Canzonery and Gray (1985)
model lies in showing how monetary policy in one country
can have a detrimental, or favourable or neutral effects in
another economies depending how the policy games is
played.
Money growth rate is smaller in the fixed rate than the
stackleberg equilibrium which is small than the Nash
equilibrium.
The welfare gains from the cooperation in the monetary
policy can be obtained by taking the differences of utilities
under these two different regimes.
Macroeconomic Themes: 14
14
Micro-Founded Models of International
Policy Co-ordination
Corsetti and Pesenti (2001) Model to asset welfare impacts of
macroeconomic inter-dependence
utility function has three arguments; composite good made of
domestic and foreign goods, real money balances and leisure.
Output in each country is produced using domestic labour.
Goods market is monopolistic and there are imperfections in the
labour market so that wage rate is not completely flexible.
Agents are free to hold domestic money or international bonds of
combination to two.
Terms of trade effect and impacts of monopolistic structures are
considered with an expansionary monetary policy.
A competitive equilibrium is a set of prices and quantities that
maximise utility for households in both domestic and foreign
countries.
Macroeconomic Themes: 14
15
Major Conclusions of Micro-Founded Models
of International Policy Co-ordination
Using closed form solutions Corsetti and Pesenti (2001) conclude
that the terms of trade effects may welfare dominate aggregate
demand externalities.
These models correct lack of micro-foundation in the traditional
Mundell-Fleming-Dornbusch models for analysis of economic
policy of open and interdependent economies including issues
such as “beggar thyself” or beggar-thy-neighbour or prosper-thyneighbour effects. In a follow up study
Benigno (2002) uses this new framework to establish new results.
He proves that Nash equilibrium is not the Pareto efficient
allocation and the co-operative solution is not credible. He shows
rationale for delegating monetary policy to a central institution.
Macroeconomic Themes: 14
16
An Important Question
How can we use above models to analyse five economic
tests for the UK to join the European Monetary Union.
These five tests include (a) cyclical convergence (b)
flexibility in economic policy (c) impacts on investment
(d) Impacts on financial services and (e) impacts on
employment and growth . Refer to HM-Treasury’s
Report on UK Membership of EMU available at
www.hm-treasury.gov.uk.
Macroeconomic Themes: 14
17
References
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Macroeconomic Themes: 14
18