International Policy Coordination
When does it matter?

Economic interdependence entails significant external influences on national economies, which can lead to inefficient outcomes if policies are formulated independently. In principle, all countries could be better off if policies were centrally coordinated. But this seems to involve considerable political effort, and few attempts have been made to determine when the economic inefficiencies that result from decentralized policy- making are sufficient to justify coordination. There has been extensive theoretical analysis of the importance of these externalities, but empirical assessments of the potential gains from coordination, such as those by CEPR Research Fellows Gilles Oudiz, Jeffrey Sachs and Andrew Hughes Hallett, have found that surprisingly small gains result from a move from non-cooperative to cooperative policy-making. Typically, this result is attributed to small 'spillover' effects of monetary policy between countries.

In Discussion Paper No. 119, Matthew Canzoneri and Research Fellow Patrick Minford use the Liverpool World Model to re- examine the empirical gains from policy coordination. Canzoneri and Minford suspected that the strong spillover effects for monetary policy in the Liverpool model would yield very different results from those of Oudiz and Sachs, for example. Their simulations showed that this conjecture was only partially correct. The presence of strong spillover effects did not guarantee that cooperative and non-cooperative policies would differ significantly; other aspects of the simulations proved equally important. The simulations revealed a more complex picture: under some assumptions, cooperative and non-cooperative policies were almost indistinguishable, while in other cases they led to very different policies.

The Liverpool World Model consists of nine countries and three trade blocs (which account for the countries not modelled directly). The model is distinguished by its assumption that expectations are formed rationally, and by the important role played by financial wealth in the functions describing the demand for both money and goods in each country. Each country model can be described in terms of its aggregate supply curve, its IS and LM curves, and a long-run constraint on government finance. Aggregate supply is influenced by unanticipated inflation, through the operation of nominal wage contracts in the unionized sector, and by the real exchange rate through the use of imported intermediate products.

The assumption of rational expectations requires that the model possesses a well specified long-run equilibrium, which in turn imposes a long-run constraint on deficit finance. In the long run, portfolio balance in the model requires a fixed ratio between money and bonds: money, bonds and financial wealth all grow at the same rate, and there is a balanced financing of fiscal deficits. In addition, there is assumed to be a fixed long-run ratio between output and real financial wealth. Therefore, the steady-state rate of growth in money and prices is proportional to the deficit-output ratio. Deflationary policies must necessarily be a combination of monetary and fiscal actions which, in this model, also lower deficit-output ratios.

In 1979, both Mr Volcker and Mrs Thatcher embarked on policies designed to lower long-run inflation rates; many other European countries followed suit. Canzoneri and Minford therefore begin their simulations with a 'world disinflation game'. In their simulations Europe is one country with a single policy-maker, which, the authors concede, does not reflect recent history. Policy-makers are assumed to know how disinflation in the United States or EC affects their output, and how it spills over to the other's output. US and European policy-makers inherit 12% inflation rates, which they think are too high; they bring steady-state inflation down to 6%, causing a recession in the process. In the authors' simulations, money supply growth is cut by 4%, and government expenditures are reduced to achieve the required reduction in the long-run deficit-output ratio. These actions are assumed to be unanticipated and permanent. The structure of the Liverpool Model implies that these contractionary policies have negative spillover effects, each making the other country's recession (and welfare) significantly worse. Decentralized policy-makers do not take account of these externalities, and the uncooperative solution is therefore too deflationary.

Despite the unsatisfactory nature of uncoordinated policy-making in some cases, the coordinated and uncoordinated policies were effectively indistinguishable. Canzoneri and Minford explored a variety of alternative assumptions in order to determine whether coordination resulted in significantly different policies. The simulations suggested that policy coordination can be important in practice as well as in theory, but that its importance depends on more than the degree of interdependence between economies (as measured by, for example, the ratio of spillover effects to 'own' effects). In the authors' simulations, policy-makers' preferences also seemed to matter, but the size and nature of the shocks to the world economy that started the simulations were most important. When policy-makers were faced with large and conflicting problems, coordination made a big difference to the inflation rates and outputs they chose. On the other hand, even with a high degree of interdependence, when the policy-makers were faced with only one problem of a moderate size the differences called for by coordination did not seem worth much effort, and sometimes were even too small to implement. Canzoneri and Minford speculate, however, that coordination might matter more in a game where there was persistent, ongoing conflict.


When International Policy Coordination Matters: An Empirical Analysis
Matthew Canzoneri and Patrick Minford

Discussion Paper No. 119, July 1986 (IM)