A Macroeconomic Policy Game for a Monetary Union with Adaptive Expectations

Abstract

Abstract: We develop a dynamic game model of a two-country monetary union to study strategic interactions between macroeconomic policy-makers in economies with adaptive inflationary expectations. In this union, governments of participating countries pursue national goals when deciding on fiscal policies, whereas the common central bank’s monetary policy aims at union-wide objective variables. For a symmetric de-mand shock, we derive numerical solutions of the dynamic game between the govern-ments and the central bank, using the OPTGAME algorithm. The different solution con-cepts for this game serve as models of a conflict between national and supra-national institutions (non-cooperative Nash equilibrium) on the one hand and of coordinated policy-making (cooperative Pareto solutions) on the other. We show that there is a trade-off between instruments ’ and targets ’ deviations from desired paths; moreover, the volatility of output and inflation increase when private agents react more strongly to changes in actual inflation