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Article Excerpt
Abstract
This paper analyzes whether international monetary policy coordination is the best response to economic interdependence. The paper develops a macroeconomic model in which countries show different preferences regarding objectives when faced with asymmetric disturbances and analyzes in strategic terms how monetary policy can deal with real, monetary, and supply-side shocks. It further shows how the desirability of monetary policy coordination depends on the presence of asymmetric shocks and also on the nature of disturbances, the channel of transmission, and the asymmetry of preferences. Finally, the paper derives the conditions under which monetary policy coordination proves to be desirable. (JEL E52, E61, F42)
Introduction
The greater the degree of economic integration among countries, the greater the spillover effects when any of the involved economies suffer a shock. The effects of the interaction among interdependent economies depend on the channels of transmission of the shocks. Since the channels of transmission are determined by the economic framework of each country, it is necessary to consider national policy interactions when adopting economic policy decisions.
Given that the immediate effect of interdependence is good policy interaction, a question arises to whether it is possible for international policy coordination to be a better response than non-cooperative solutions. The theoretical arguments supporting policy coordination are based on the idea that cooperation internalizes the effects of economic interdependence, which no government can achieve individually. In this context, the strategic behavior of the authorities must be considered. Therefore, the game theory approach is used to study how authorities deal with shocks.
The first author to study game theory was Hamada [1976]. He used it to study international policy coordination by means of a two-country model where governments' objectives were price stability and balance-of-payments equilibrium. Hamada showed that these objectives cannot be met simultaneously in a system of fixed exchange rate where the level of credit expansion is the only policy instrument. This is because the interests of each country would be in conflict under fixed exchange rate. Even under flexible exchange rate, the non-cooperative solution would be suboptimal.
There is a large number of later contributions examining international cooperation in strategic terms [see Cooper, 1985; Corden, 1985a and 1985b; Canzoneri and Gray, 1985; Currie and Levine, 1985; Kehoe, 1987; and Gutierrez, 2003 for a survey]. In general, these studies show that when the authorities ignore interdependence, the solutions will not be optimal and conclude that when authorities cooperate, the result would be Pareto superior.
These results justified international policy coordination from a theoretical point of view. However, subsequent empirical studies revealed that the benefits of coordination were not very clear [see Oudiz and Sachs, 1984; Frankel and Rockett, 1988; and Douven and Plasmans, 1995], nor were they greater than those obtained following a simple exchange of information. However, when conflict of interest and interdependence among countries is large enough, some benefits from coordination may be obtained if policy is credible.
In recent years, literature on coordination has recovered a new interest [see Bryant, 1995; Hughes et al., 1995; Sibert, 1997; Beetsma and Bovenberg, 1998 and 2001; and Benigno, 2002] because of the European Monetary Union. Since a monetary union is one of the possible infinite cooperative solutions, forming a European Monetary Union could be interpreted as an explicit way of taking advantage of monetary policy coordination. In such an environment, Neck et al. [1999], Haber et al. [2002], and van Aarle et al. [2002] find that cooperation between fiscal policymakers and the European Central Bank (ECB) is better than other scenarios.
The aim of this paper is to show how the international economic framework determines the spillover effects of the shocks and to study how monetary policy coordination can internalize these externalities by obtaining the conditions under which cooperation would be desirable. For this purpose, the paper develops a two-country model where countries with different preferences on output and price targets suffer asymmetric demand-side and supply-side shocks.
Since these types of shocks can make the operation of the European Monetary Union difficult, recent literature has focused on the effects of asymmetric shocks. This idea, already mentioned in the literature on optimum currency areas [Mundell, 1961], has gathered more interest recently [see Cohen and Wyplosz, 1989; De Grauwe and Vanhaverbeke, 1993; Erkel-Rouse and Melitz, 1995; Helg et al., 1995; Ballabriga et al., 1999; and Forni and Reichlin, 2001]. For that reason, this paper focuses on the short-run effects of asymmetric shocks by showing the conditions that could support monetary policy coordination and eventually the formation of a monetary union. In other words, the results obtained could be useful in evaluating the potential benefits of reaching a higher level of monetary coordination or even of joining a monetary union.
The analysis is particularly relevant because it shows conditions under which monetary policy coordination offsets the adverse effects of shocks. In relation to other similar studies, the particular contribution of this paper extends the traditional demand-side two-country models by including the supply-side model with asymmetries (both in disturbances and preferences) and analyzing the role of the channels of transmission of the disturbances.
The results of the analysis lead to a conclusion of whether the characterization of shocks as symmetric or asymmetric is a necessary but not sufficient condition to determine the desirability of monetary policy coordination. The nature (monetary, real, or supply-side) of the shock,...
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