Dynamic Modeling of Monetary and Fiscal Cooperation Among Nations (Dynamic Modeling and Econometrics in Economics and Finance)

335 Pages·2006·5.51 MB·English

by  Joseph Plasmans

Dynamic Modeling of Monetary and Fiscal Cooperation
Among Nations
Dynamic Modeling and Econometrics in Economics
and Finance
VOLUME 8
Series Editors
Stefan Mittnik, University of Kiel, Germany
Willi Semmler, University of Bielefeld, Germany and
New School for Social Research, U.S.A.
Aims and Scope
The series will place particular focus on monographs, surveys, edited volumes,
conference proceedings and handbooks on:
• Nonlinear dynamic phenomena in economics and finance, including equilibrium,
disequilibrium, optimizing and adaptive evolutionary points of view; nonlinear and
complex dynamics in microeconomics, finance, macroeconomics and applied fields
of economics.
• Econometric and statistical methods for analysis of nonlinear processes in
economics and finance, including computational methods, numerical tools and
software to study nonlinear dependence, asymmetries, persistence of fluctuations,
multiple equilibria, chaotic and bifurcation phenomena.
• Applications linking theory and empirical analysis in areas such as macrodynamics,
microdynamics, asset pricing, financial analysis and portfolio analysis, international
economics, resource dynamics and environment, industrial organization and
dynamics of technical change, labor economics, demographics, population
dynamics, and game theory.
The target audience of this series includes researchers at universities and research and
policy institutions, students at graduate institutions, and practitioners in economics,
finance and international economics in private or government institutions.
Dynamic Modeling of Monetary
and Fiscal Cooperation
Among Nations
by
Joseph Plasmans
University of Antwerp, Belgium
and Tilburg University, The Netherlands
Jacob Engwerda
Tilburg University, The Netherlands
Bas van Aarle
University of Maastricht,The Netherlands
Giovanni Di Bartolomeo
University of Rome "La Sapienza",
Rome, Italy
and
Tomasz Michalak
University of Antwerp, Belgium
AC.I.P. Catalogue record for this book is available from the Library of Congress.
ISBN-10 0-387-27884-2 (HB)
ISBN-13 978-0-387-27884-1 (HB)
ISBN-10 0-387-27931-8 (e-book)
ISBN-13 978-0-387-27931-2 (e-book)
Published by Springer,
P.O. Box 17, 3300 AADordrecht, The Netherlands.
www.springer.com
Printed on acid-free paper
All Rights Reserved
©2006 Springer
No part of this work may be reproduced, stored in a retrieval system, or transmitted
in any form or by any means, electronic, mechanical, photocopying, microfilming, recording
or otherwise, without written permission from the Publisher, with the exception
of any material supplied specifically for the purpose of being entered
and executed on a computer system, for exclusive use by the purchaser of the work.
Printed in the Netherlands.
Contents
Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix
Acknowledgement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi
List of abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii
List of symbols . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv
1 International Policy Coordination 1
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
1.2 The textbook approach . . . . . . . . . . . . . . . . . . . . . . . 3
1.3 A more general view . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.3.1 Can cooperation be counterproductive? . . . . . . . . . . 7
1.3.2 Cooperation, commitment and credibility . . . . . . . . . 9
1.3.3 The rule of uncertainty . . . . . . . . . . . . . . . . . . . 10
1.4 Monetary and fiscal coordination in an MU . . . . . . . . . . . . 11
1.4.1 Principles of a monetary union . . . . . . . . . . . . . . . 11
1.4.2 A textbook illustration of the OCA problem. . . . . . . . 13
1.4.3 Monetary and fiscal policy in an MU . . . . . . . . . . . . 14
1.5 Coordination at work - the EMU . . . . . . . . . . . . . . . . . . 16
1.5.1 European monetary integration processes . . . . . . . . . 16
1.5.2 Design of monetary and fiscal policies . . . . . . . . . . . 19
1.5.3 Asymmetriesinmacroeconomicshocks,policypreferences,
sizes and structures . . . . . . . . . . . . . . . . . . . . . 21
1.5.4 Macroeconomic policy coordination. . . . . . . . . . . . . 21
1.5.5 A textbook example of policy coordination in the EMU . 24
1.5.6 Brief general literature overview . . . . . . . . . . . . . . 28
1.6 Coordination at work - other international arrangements . . . . . 30
1.6.1 The G-7 process . . . . . . . . . . . . . . . . . . . . . . . 30
1.6.2 Financial crises in emerging markets - the need for inter-
national coordination . . . . . . . . . . . . . . . . . . . . 33
1.6.3 Some general observations on coordination experiences . . 36
1.7 A look ahead . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2 Mathematical Background 41
2.1 Linear algebra. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41
2.2 The basic mathematical model . . . . . . . . . . . . . . . . . . . 51
v
vi CONTENTS
2.3 The one-player case . . . . . . . . . . . . . . . . . . . . . . . . . 54
2.4 The cooperative game . . . . . . . . . . . . . . . . . . . . . . . . 60
2.5 The non-cooperative game . . . . . . . . . . . . . . . . . . . . . 67
2.6 The game with coalitions . . . . . . . . . . . . . . . . . . . . . . 77
3 The Basic Symmetric Two-Country Model 85
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85
3.2 A dynamic stabilization game in an MU . . . . . . . . . . . . . . 86
3.3 Non-cooperative and cooperative fiscal policies . . . . . . . . . . 89
3.3.1 The non-cooperative case . . . . . . . . . . . . . . . . . . 89
3.3.2 The cooperative case . . . . . . . . . . . . . . . . . . . . . 91
3.3.3 The e(cid:30)ect of fiscal stringency conditions on adjustment
speed (cid:24) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
3.3.4 Consequences of a European federal transfer system . . . 95
3.4 Numerical simulations with the model . . . . . . . . . . . . . . . 97
3.5 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103
4 An MU Model with Active Monetary Policy 111
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
4.2 An MU model with active monetary policy . . . . . . . . . . . . 112
4.3 Monetary policy management in an MU . . . . . . . . . . . . . . 113
4.4 Macroeconomic policy design in the MU . . . . . . . . . . . . . 116
4.4.1 The non-cooperative case . . . . . . . . . . . . . . . . . . 117
4.4.2 The cooperative case . . . . . . . . . . . . . . . . . . . . . 118
4.4.3 Cases with policymakers’ coalitions . . . . . . . . . . . . 118
4.4.4 Some coalition formation terminology . . . . . . . . . . . 119
4.5 The symmetric case . . . . . . . . . . . . . . . . . . . . . . . . . 119
4.5.1 The various equilibrium strategies . . . . . . . . . . . . . 120
4.5.2 First findings. . . . . . . . . . . . . . . . . . . . . . . . . 121
4.6 A simulation study . . . . . . . . . . . . . . . . . . . . . . . . . 122
4.6.1 Baseline: A symmetric MU . . . . . . . . . . . . . . . . . 123
4.6.2 Asymmetric fiscal policy preferences . . . . . . . . . . . . 126
4.6.3 Asymmetric monetary policy transmission . . . . . . . . . 128
4.6.4 Asymmetric bargaining powers . . . . . . . . . . . . . . . 130
4.6.5 Asymmetric degree of competitiveness . . . . . . . . . . . 132
5 Endogenous Coalition Formation Concepts 145
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145
5.2 General setting and definitions . . . . . . . . . . . . . . . . . . . 146
5.3 Single-agreement games . . . . . . . . . . . . . . . . . . . . . . . 154
5.3.1 External and internal stability . . . . . . . . . . . . . . . 154
5.4 Multiple-agreement games . . . . . . . . . . . . . . . . . . . . . . 156
5.4.1 Simultaneous games - classic setting . . . . . . . . . . . . 156
5.4.2 Simultaneous games - MU setting. . . . . . . . . . . . . . 163
5.4.3 Alternative way to find stable coalition structures in si-
multaneous games . . . . . . . . . . . . . . . . . . . . . . 170
CONTENTS vii
5.4.4 Sequential negotiation game . . . . . . . . . . . . . . . . . 180
5.5 Institutional design and equilibrium concepts . . . . . . . . . . . 185
5.6 Social optimum and indices . . . . . . . . . . . . . . . . . . . . . 189
5.7 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191
6 A Multi-Country Closed-Economy MU Model 197
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 197
6.2 Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
6.3 Numerical solutions of the model . . . . . . . . . . . . . . . . . . 200
6.3.1 Symmetric baseline model . . . . . . . . . . . . . . . . . 200
6.3.2 The role of spillovers . . . . . . . . . . . . . . . . . . . . . 212
6.3.3 Structural asymmetric setting . . . . . . . . . . . . . . . . 215
6.3.4 Structural asymmetric setting with asymmetric bargain-
ing power . . . . . . . . . . . . . . . . . . . . . . . . . . . 219
6.4 Concluding remarks . . . . . . . . . . . . . . . . . . . . . . . . . 222
6.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
7 Accession to a Monetary Union 229
7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 229
7.2 The basic economic framework . . . . . . . . . . . . . . . . . . . 232
7.3 International economic interdependencies . . . . . . . . . . . . . 235
7.4 General aspects of accession . . . . . . . . . . . . . . . . . . . . 236
7.5 Numerical solutions of the model . . . . . . . . . . . . . . . . . . 238
7.5.1 General setup . . . . . . . . . . . . . . . . . . . . . . . . . 238
7.5.2 Pre-accession stage, symmetric model . . . . . . . . . . . 241
7.5.3 Post-accession stage, symmetric model . . . . . . . . . . . 247
7.5.4 Asymmetry in the model . . . . . . . . . . . . . . . . . . 251
7.5.5 Stable coalition structures . . . . . . . . . . . . . . . . . . 253
7.5.6 E(cid:30)ects of accession . . . . . . . . . . . . . . . . . . . . . . 258
7.6 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
7.7 Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 264
7.8 Appendix B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 269
7.9 Appendix C . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 270
8 World-wide Regional Policy Coordination 273
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
8.2 Model of international economy . . . . . . . . . . . . . . . . . . 275
8.2.1 A setting for two MUs . . . . . . . . . . . . . . . . . . . . 276
8.2.2 Parameterization . . . . . . . . . . . . . . . . . . . . . . . 277
8.2.3 Shocks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
8.3 Results of numerical simulations . . . . . . . . . . . . . . . . . . 279
8.3.1 Symmetric scenario (cid:118)(cid:102)1 . . . . . . . . . . . . . . . . . . . 279
8.3.2 Asymmetric scenario (cid:118)(cid:102)2 . . . . . . . . . . . . . . . . . . . 288
8.3.3 Asymmetric scenario (cid:118)(cid:102)3 . . . . . . . . . . . . . . . . . . . 289
8.3.4 Normative analysis - social optima . . . . . . . . . . . . . 289
viii CONTENTS
8.3.5 Positiveanalysis-stablecoalitionstructuresintheEMG(cid:6)((cid:3)) 292
8.4 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
8.5 Appendix . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 296
9 Concluding Remarks 303
10 References 309
Preface
Thisbookanalyzestheconductofmonetaryandfiscalstabilizationpoliciesand
cooperation among monetary and fiscal policymakers using a dynamic game
framework. The volume presents in a concise manner the results obtained from
anextensiveresearchprojectonmonetaryandfiscalpolicydesigninthe(Euro-
pean) Economic and Monetary Union (EMU). In addition, techniques and con-
clusions of this research on EMU are used to construct a more general theory
of macroeconomic cooperation between nations in a world-wide setting, mainly
in the later chapters of the book. In this way, the book provides more insights
into recent initiatives aiming to create monetary unions or other possible forms
of macroeconomic cooperation. In fact, such initiatives are recently considered
in all major regions of the world.
The analysis of stabilization policies in a monetary union is carried out
using a simplified version of (New-) Keynesian dynamic open-economy macro-
economic models, in which economic linkages between countries form a kernel
part. Such linkages give rise to many spillovers and economic externalities con-
nectedwithmacroeconomicpoliciesofnation-basedagents(governmentsand/or
central banks). This implies that the evolution of the economies over time is
important, and, therefore, dynamic modelling shall be used. Indeed, dynamic
modelshavethecharacteristicthatthestatevector,describingthecurrentstate
ofthe economyata certain pointoftime, is a(cid:30)ected byactions ofdi(cid:30)erentpol-
icymakers. Hence, economic externalities arising from individual policies and
their propagation over time are explicitly taken into account. In its most ex-
tensive setting, an (cid:113)-countries, (cid:112)-central banks dynamic model of (possible)
multiple monetary unions results.
Sinceeverypolicymakerisprimarilyinterestedinsolvingthepolicyissuesof
her own country, the induced economic spillovers and externalities may be im-
portant. Hence, the natural question of possible gains from cooperation arises.
If these gains are present, the presence of institutional settings that support
desired cooperation becomes an important issue. To model potential coopera-
tion of individually optimizing players, the approach in this book combines the
recent literature on dynamic games among monetary and fiscal policymakers
(e.g. Engwerda (1998a) and Engwerda et al. (1999, 2002)) with that on en-
dogenous coalition formation (e.g. Bloch (1996), Ray and Vohra (1997, 1999)
and Yi (1997)).
Thebookisasmuchaspossibleself-containedandwritteninamannerwell
understandable for graduate university students. Together with scholars and
researchers at universities and international institutions, they constitute the
most important readership of the book. The contents and form of the volume
are designed in a way that enables it to be used as a textbook for a specialized
course in the area of policymaking in the presence of (a) monetary union(s).
Wehopethatourgeneralperspectiveandpotentialtoapplythemodelwith
its results to di(cid:30)erent regions of the world make the book interesting for less
academic-oriented readers, such as policymakers and policy advisors through-
out. Therefore, thebookmayconstitutea valuablecontribution to theongoing
ix