In recent years countries have attempted to coordinate their economic policies, but progress appears to be easier to achieve in monetary than in commercial policy. In Discussion Paper No. 235, Flavio Delbono, Vincenzo Denicolò and CEPR Governor Giorgio Basevi propose an explanation of the apparent lack of success in coordinating commercial policies. Commercial policies, they argue, may play a `strategic' role as a threat which is used to induce other countries to cooperate over monetary policies. Recent conflicts between the US, Germany and Japan can be interpreted in this fashion: the deficit country tries to induce the two surplus countries to cooperate over demand management by threatening that, in the absence of such cooperation, it will adopt relative price policies (dollar depreciation or protectionism) aimed at correcting its current account imbalance.
Basevi, Delbono and Denicolò analyse the strategic relationship between monetary and commercial policies within the theoretical framework of an overlapping-generations model with two goods, which are traded by two countries. Each country produces only one of the goods, and each may impose an ad-valorem tariff on imports. The tariff revenue is wholly spent on domestic output. Money prices of consumption goods and the exchange rate are flexible, but it is assumed that money wages are rigid and set above market-clearing level. As a result there is Keynesian unemployment in the labour markets of both countries: actual employment is determined by labour demand (the short side of the market).

An increase in the money supply in the home country increases the domestic level of employment, but causes a deterioration in the terms of trade for the home country. It does not affect employment in the foreign country because the exchange rate is perfectly flexible. Hence, an increase in the money supply of the home country has both positive and negative effects on the home country itself and a positive effect on the foreign country (through the terms of trade). The authors first assume that tariffs are fixed and that each government controls only its own supply of money: in a single-period game each country's money supply is lower than that which would be chosen in a cooperative equilibrium. The result is equilibrium with a positive level of unemployment in both countries.
The authors then introduce the notion of threats or `punishments'. The strategy of each country consists in choosing a value of its money supply and a `threat', a function that links its tariff to the supply of money chosen by the other country. In this model even the single-period game can lead to an equilibrium with the optimal quantities of money, no unemployment and no tariffs. Each country, provided it can credibly threaten the other with a tariff, can in effect choose its preferred value for the money supply of the other country. Since each country unambiguously prefers an expansionary policy in the other country, overall full employment follows.
This result does depend on the restrictive assumption that each country spends the revenue from its tariff only on the good it produces, which implies that employment levels in both countries do not depend on the tariffs levied. Even when such assumptions are relaxed, however, the authors still find that the game with tariff threats converges to the cooperative equilibrium `more quickly' than the game without tariffs. The desire for cooperation over monetary policy may explain why countries brandish the threat of protectionism, the authors conclude.

International Monetary Cooperation under Tariff Threats
Giorgio Basevi, Flavio Delbono & Vincenzo Denicolò

Discussion Paper No. 235, May 1988 (IM/IT)