Before these particular issues are addressed, it is useful to review the assumptions underlying the standard Mundell-Fleming models and the consequent effects of fiscal and monetary policy on output and employment. The Mundell-Fleming model of a small open economy assumes fixed prices of goods and labour and only considers aggregate demand; it also ignores expectational dynamics. A more fully specified model also considers aggregate supply. The Mundell-Fleming model also assumes that nominal wages are rigid and its qualitative conclusions on the effectiveness of monetary and fiscal policies are not robust to the assumptions concerning the degree of real or nominal wage rigidity.
In a two-country Mundell-Fleming model a home monetary expansion increases net exports of the home country, so that home output increases and foreign output decreases. In other words, monetary expansion is a beggar-thy-neighbour policy. Similarly, fiscal expansion is a locomotive policy. The nature of these spillover effects depends, however, on the assumption of nominal wage rigidity in both countries. When both countries have real wage rigidity, monetary expansion has no real effects while fiscal expansion is a beggar-thy-neighbour policy (as the associated appreciation of the real exchange rate increases the foreign wedge). More interestingly when one country (say Europe) has real wage rigidity and the other (the US) has nominal wage rigidity, a European fiscal expansion and a US monetary expansion are locomotive policies while a US fiscal expansion is, typically, a beggar-thy-neighbour policy. In the absence of international policy coordination, the European fiscal stance is too tight from the US point of view and too loose from the European point of view while US fiscal policy is, typically, too loose. Some German commentators might have in mind a world in which the law of one price (purchasing power parity) rules, because they argue that (European) fiscal policy has no real effects whatsoever (as it cannot affect the wedge) and therefore should be set at a level consistent with no inflation. The asymmetric two-country model presented in this paper allows a better understanding both of recent suggestions for international policy coordination and of why recovery in Europe has proved so difficult.
The merits of international policy coordination are usually assessed using the techniques of differential game theory. For example, Miller and Salmon, Currie and Levine, and Oudiz and Sachs use symmetric two-country models characterized by real exchange rate overshooting, nominal wage rigidity and a natural rate of unemployment in order to investigate the gains from coordination during a period of monetary disinflation. Since reductions in monetary growth in such models are a beggar-thy- neighbour policy, the non-cooperative (Nash) equilibrium gives rise to excessively fast disinflation relative to the cooperative solution. These results assume that the central banks can precommit themselves. When they cannot, international policy coordination may be counter-productive: in the absence of international policy coordination, a surprise increase in monetary growth induces a depreciation of the exchange rate and imposes the penalty of higher inflation on the monetary authority. In the presence of coordination, such a disincentive does not exist, and so coordination may diminish the authority's credibility. It is also possible that coordination between two countries (say, France and Germany) is counter-productive, because it may provoke an adverse response from a third country (say the US).
Interesting empirical work in this area has only just started (e.g. Oudiz and Sachs, 1984; McKibbin and Sachs, 1986). The present paper builds on this work and attempts to assess the merits of coordination of fiscal and supply-side as well as monetary policies in two-country models with real and nominal wage rigidity.
The four main objectives of this paper are: (i) to provide new empirical evidence on real and nominal wage rigidity in the OECD economies; (ii) to develop a convenient diagrammatic exposition of the spillover effects of fiscal, monetary and supply-side policies in a two-country model with floating exchange rates, perfect capital mobility and wage rigidity; (iii) to analyse, with the aid of simple game theory, the nature of the bias in economic policies arising from the lack of international policy coordination; and (iv) to analyse the effects of an oil shock in a two-country model with real wage rigidity at home and nominal wage rigidity abroad.
Section 2 examines the behaviour of unemployment, inflation, competitiveness, interest rates, monetary policy, fiscal stance and supply-side policies in the seven largest OECD economies during the 1970s and 1980s. Section 2 also estimates for these seven economies annual wage equations based on the error- correction model, in order to investigate which economies have a significant degree of nominal wage rigidity in the short run. It turns out that Canada, the UK and the US show evidence of nominal wage rigidity, but that France, Germany, Italy and Japan have real wage rigidity. Section 3 then sets up an analytical two- country model with floating exchange rates, uncovered interest parity, imperfect substitution between home and foreign goods, and sluggish labour market adjustment. Each country can have rigidity in either nominal or real wages. If nominal wages are rigid, their growth is determined by monetary growth. If on the other hand there is real wage rigidity, the consumers' wage is constant. The only dynamics in this model arise from the real exchange rate, which is assumed to be governed by perfect foresight, so that for unanticipated permanent shocks the transition to the new equilibrium is instantaneous. Section 4 considers a world with nominal wage rigidity at home and abroad, which is closest to the conventional Mundell-Fleming world, and develops a convenient diagrammatic apparatus to analyse the spillover effects of various economic policies. It is shown that an expansion in monetary growth and a cut in taxes are beggar-thy-neighbour policies: they lead to a fall in the world real interest rate, an excess demand for foreign money, a downward pressure on the foreign price level, and therefore an increase in the foreign real wage and fall in foreign output. Fiscal expansion is, on the other hand, a locomotive policy. Section 4 also assesses the merits of international policy coordination using a discounted social welfare loss function that depends on output and inflation (through the consumers' price index). In the absence of international policy coordination, optimal monetary growth is too high.
Section 5 considers a world with real wage rigidity at home and abroad. Now monetary growth has no real effects, while fiscal expansion is a beggar-thy-neighbour policy (as the associated appreciation of the real exchange rate increases the wedge between the foreign producers' and consumers' wage). Supply-side improvements are a locomotive policy (as they lead to a depreciation of the real exchange rate and therefore to a fall in the foreign wedge). Section 5 also assesses policy coordination using discounted social welfare loss functions which depend on output and the public deficit. In the absence of coordination, fiscal policy is too loose.
Section 6 considers an asymmetric world with real wage rigidity at home (Europe and Japan) and nominal wage rigidity abroad (Canada and the US). Now a European fiscal expansion, an increase in US monetary growth and a US tax cut are locomotive policies, while a European tax cut and, typically, a US fiscal expansion are beggar-thy-neighbour policies. Oil price shocks typically hit European output and employment much harder than US output and employment. It follows that, in the absence of international coordination and in the aftermath of the OPEC oil shocks, the European fiscal stance is too tight from the US point of view and too loose from the European point of view, while the US fiscal stance is, typically, too loose and the US monetary growth rate is too low.