Dynamic modelling of monetary and fiscal cooperation among nations (Q820221): Difference between revisions

This book applies a dynamic game theory framework to explore aspects of the theory of monetary unions. The specific example in mind is the European Monetary Union (EMU). The objective of each central bank is set as a dynamic optimization problem in which the central bank endeavors to minimize a loss function which penalizes high inflation, low output (hence high levels of unemployment) and high fiscal deficits. The authors assume a New-Keynesian macroeconomic framework in which a (New Keynesian) Phillips curve is present. This Phillips curve essentially postulates that the monetary authorities face some trade-off between inflation and recession in the short-run. The dynamic behavior of the aggregate output, price level, exchange rates and other relevant variables can be described by a set of ordinary first order linear differential equations, and the objective of each central bank is to minimize the flow of the quadratic loss function previously described. Questions which are explored include: the benefits of co-operation versus non-co-operation, various equilibrium strategies, the endogenous formation of coalitions, problems of enlargement of the unions, and regional policy co-ordination. The main strength of this book is its high profile subject matter. The benefits and pitfalls of monetary unions are being vigorously debated in Europe, at the moment, with strong attempts at coaching from the sideline by not-so-disinterested American-based economists and politicians. This book applies a very standard version of dynamic game theory. It is very honest in not claiming any novelty in that respect. It also borrows a long rehearsed version of macroeconomic modeling, known as the New Keynesian theory. Its contribution is in exploring a number of issues under the single roof of their representation of each economy as a system of linear differential equations. One aspect, which is obviously absent from this exercise, is of the congruence of this modeling with the data. Once again, the authors are very frank about that fact and do not make any pretence of addressing the empirical issue of relevance of their model. While they deserve full marks for their candor, the authors really ought to have made a better attempt to convince the readers of the interest of their work, especially since their names are not so well established in the field. One is left with the impression that there is more to monetary union than just the set of dynamic equations on which the book focuses. Indeed, the reader is left wanting for a chapter which would have organized the expensive literature about the Euro which is currently developing rapidly. Without such introduction, the place and contribution of this book to the literature remains somewhat unclear.