Policy Coordination
I don't want to commit myself

Although one might take for granted that policy objectives in an interdependent world may be better achieved when governments cooperate than when national decisions are arrived at in an uncoordinated fashion, theoretical and empirical research to date has not supported this view. Individual governments appear to be able to achieve their output and inflation targets just as well by choosing their own monetary rules as by international cooperation. In Discussion Paper No. 115, Research Fellow Frederick van der Ploeg attempts to analyse the long-run scope for coordination of monetary policies, both when individual countries can and when they cannot 'precommit' themselves to carry out announced policies. Van der Ploeg investigates whether substantial gains from cooperation might arise in the presence of a genuine long-run inflation-output trade-off.

Van der Ploeg uses a classical model of two interdependent economies in which capital accumulation occurs. Exchange rates are flexible and their behaviour is governed by uncovered interest rate parity. The model is characterized by a 'worldwide' Mundell-Tobin effect. When one country increases its monetary growth rate, its domestic inflation rate increases, the world real rate of interest falls, and the level of world economic activity increases.

Each country wishes to transfer the burden of lowering the world real interest rate to the other country, as this would bring gains in employment, output and its capital stock without the costs of higher inflation. Although there is an incentive for both countries to pursue more expansionary monetary growth rates, there are no such incentives for one country to do this alone. Here the case for cooperation becomes much stronger and is also relevant in the long run, for if both countries are prepared to live with higher anticipated inflation rates, a higher level of activity and of economic welfare could be achieved by both countries. These considerations give rise to a long-run role for international coordination of monetary policies, in contrast to the transient role previously found in models with Keynesian rigidities, in which coordination can prevent exchange rate over- shooting.

This policy prescription may not be so robust, van der Ploeg notes, with respect to plausible changes in the specification of the model. The scope for international policy coordination outlined above presumes that policy announcements are credible, in that Central Banks can precommit themselves to carry out their announcements concerning present and future monetary policies. But policy coordination may affect their credibility. With non- cooperative decision-making each government may be discouraged from reneging on its announced policies, for the levy of a surprise inflation tax would induce an exchange rate depreciation and impose inflation costs. International policy coordination avoids such a depreciation and as a result the private sector may believe that a government is more likely to renege.

Van der Ploeg uses the game theoretic concepts of Nash and Stackelberg equilibria to analyse the potential long-run gains from coordination by comparing various competitive and cooperative outcomes. He first considers the situation where each government can precommit itself to its announced monetary policies. Here cooperation is unambiguously superior to competitive policy formulation, since coordination achieves a reduction in the world real rate of interest. The 'rules' outcome suffers from time inconsistency, however, since each government has an incentive to levy a 'surprise' inflation tax. Van der Ploeg then examines time-consistent, and hence credible, monetary policies. He finds that the resulting outcomes are no different from the credible outcomes under competitive policy formulation. Both lead to excessive monetary growth rates and to higher levels of activity than under coordinated or competitive policy formulation with precommitment. Both coordinated and competitive decision-making without precommitment therefore lead to higher inflation rates, higher levels of activity and, van der Ploeg argues, lower welfare than either policy coordination or competitive decision-making with precommitment. Hence, he concludes, in the absence of precommitment, which could arise through binding contracts or through governments' concern for their reputation, policy coordination is not beneficial.

Van der Ploeg suggests that this analysis could be extended to three or more interdependent economies. If the two countries considered above are the United States and Europe, then it is assumed that the individual countries that make up Europe cooperate and coordinate their policies. But if the member states of Europe engage in competitive policy formulation in the presence of international externalities, then the aggregate reaction curve of Europe will be different. Cooperation within Europe may engender a deflationary response by the United States, which could conceivably make coordination of European policies counter-productive, according to van der Ploeg.


Capital Accumulation, Inflation and Long-Run Conflict in International Objectives
Frederick van der Ploeg

Discussion Paper No. 115, June 1986 (IM)