Monetary policy strategies in the world economy carlberg_4 pptx

As a result, given a common supply shock, monetary interaction produces zero inflation in Europe.. Given a common supply shock, monetary interaction produces zero inflation in Europe.. W

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2) A common supply shock In each of the regions, let initial unemployment

be zero, and let initial inflation be zero as well Step one refers to the common

supply shock In terms of the model there is an increase in B1 of 3 units, as there

is in A1 And there is an increase in B2 of 3 units, as there is in A2 Step two

refers to the outside lag Inflation in Europe goes from zero to 3 percent, as does

inflation in America Unemployment in Europe goes from zero to 3 percent, as

does unemployment in America

Step three refers to the policy response According to the Nash equilibrium

there is a reduction in European money supply of 4 units and a reduction in

American money supply of 2 units Step four refers to the outside lag Inflation in

Europe goes from 3 to zero percent Inflation in America stays at 3 percent

Unemployment in Europe goes from 3 to 6 percent And unemployment in

America stays at 3 percent Table 3.16 gives an overview

Table 3.16

Monetary Interaction between Europe and America

A Common Supply Shock

First consider the effects on Europe As a result, given a common supply shock, monetary interaction produces zero inflation in Europe However, as a side effect, it raises unemployment there Second consider the effects on America As a result, monetary interaction has no effect on inflation and unemployment in America The initial loss of each central bank is zero The common supply shock causes a loss to the European central bank of 9 units and a loss to the American central bank of 18 units Then monetary interaction reduces the loss of the European central bank from 9 to zero units On the other hand, it keeps the loss of the American central bank at 18 units

3) A common mixed shock In each of the regions, let initial unemployment

be zero, and let initial inflation be zero as well Step one refers to the common mixed shock In terms of the model there is an increase in B1 of 6 units and an increase in B2 of equally 6 units Step two refers to the outside lag Inflation in Europe goes from zero to 6 percent, as does inflation in America Unemployment

in Europe stays at zero percent, as does unemployment in America

Step three refers to the policy response According to the Nash equilibrium there is a reduction in European money supply of 10 units and a reduction in American money supply of 8 units Step four refers to the outside lag Inflation in Europe goes from 6 to zero percent Inflation in America goes from 6 to 3 percent Unemployment in Europe goes from zero to 6 percent And unemployment in America goes from zero to 3 percent For a synopsis see Table 3.17

First consider the effects on Europe As a result, given a common mixed shock, monetary interaction produces zero inflation in Europe However, as a side effect, it produces unemployment there Second consider the effects on America As a result, monetary interaction lowers inflation in America On the other hand, it raises unemployment there The initial loss of each central bank is zero The common mixed shock causes a loss to the European central bank of 36 units and a loss to the American central bank of equally 36 units Then monetary interaction reduces the loss of the European central bank from 36 to zero units Similarly, it reduces the loss of the American central bank from 36 to 18 units

2 Some Numerical Examples

90

Table 3.17

Monetary Interaction between Europe and America

A Common Mixed Shock

4) Another common mixed shock In each of the regions, let initial

unemployment be zero, and let initial inflation be zero as well Step one refers to

the common mixed shock In terms of the model there is an increase in A1 of 6

units and an increase in A2 of equally 6 units Step two refers to the outside lag

Unemployment in Europe goes from zero to 6 percent, as does unemployment in

America Inflation in Europe stays at zero percent, as does inflation in America

Step three refers to the policy response According to the Nash equilibrium

there is an increase in European money supply of 2 units and an increase in

American money supply of 4 units Step four refers to the outside lag

Unemployment in Europe stays at 6 percent Unemployment in America goes

from 6 to 3 percent Inflation in Europe stays at zero percent And inflation in

America goes from zero to 3 percent For an overview see Table 3.18

First consider the effects on Europe As a result, given another common

mixed shock, monetary interaction produces zero inflation in Europe However,

as a side effect, it produces unemployment there Second consider the effects on

Monetary Interaction between Europe and America: Case C

America As a result, monetary interaction lowers unemployment in America On

the other hand, it raises inflation there The initial loss of each central bank is

zero The common mixed shock causes a loss to the European central bank of

zero units and a loss to the American central bank of 36 units Then monetary

interaction keeps the loss of the European central bank at zero units And what is

more, it reduces the loss of the American central bank from 36 to 18 units

Table 3.18

Monetary Interaction between Europe and America

Another Common Mixed Shock

5) Summary Given a common demand shock, monetary interaction produces

zero inflation and zero unemployment in each of the regions Given a common

supply shock, monetary interaction produces zero inflation in Europe And what

is more, monetary interaction has no effect on inflation and unemployment in

America Given a common mixed shock, monetary interaction produces zero

inflation in Europe And what is more, monetary interaction lowers inflation in

America On the other hand, it raises unemployment there

2 Some Numerical Examples

92

Chapter 4

Monetary Cooperation

between Europe and America: Case A

The model of unemployment and inflation can be characterized by a system

As to policy targets there are three distinct cases In case A the targets of

monetary cooperation are zero inflation in Europe and America In case B the

targets of monetary cooperation are zero inflation and zero unemployment in

each of the regions In case C the targets of monetary cooperation are zero

inflation in Europe, zero inflation in America, and zero unemployment in

America This chapter deals with case A, and the next chapters deal with cases B

and C

The policy makers are the European central bank and the American central

bank The targets of monetary cooperation are zero inflation in Europe and

America The instruments of monetary cooperation are European money supply

and American money supply There are two targets and two instruments We

assume that the European central bank and the American central bank agree on a

common loss function:

L is the loss caused by inflation in Europe and America We assume equal

weights in the loss function The specific target of monetary cooperation is to

minimize the loss, given the inflation functions in Europe and America Taking

M Carlberg, Monetary and Fiscal Strategies in the World Economy, 92

DOI 10.1007/978-3-642-10476-3_12, © Springer-Verlag Berlin Heidelberg 2010

account of equations (3) and (4), the loss function under monetary cooperation

can be written as follows:

Equation (7) shows the first-order condition with respect to European money

supply And equation (8) shows the first-order condition with respect to

American money supply

The cooperative equilibrium is determined by the first-order conditions for a

minimum loss The solution to this problem is as follows:

Equations (9) and (10) show the cooperative equilibrium of European money

supply and American money supply As a result there is a unique cooperative

equilibrium An increase in B1 causes a reduction in both European and

American money supply Obviously, the cooperative equilibrium is identical to

the corresponding Nash equilibrium That is to say, monetary cooperation case A

is equivalent to monetary interaction case A For some numerical examples see

Chapter 1

Monetary Cooperation between Europe and America: Case A

94

Chapter 5

Monetary Cooperation

between Europe and America: Case B

The model of unemployment and inflation can be represented by a system of

The policy makers are the European central bank and the American central

bank The targets of monetary cooperation are zero inflation and zero

unemployment in each of the regions The instruments of monetary cooperation

are European money supply and American money supply There are four targets

but only two instruments, so what is needed is a loss function We assume that

the European central bank and the American central bank agree on a common

loss function:

L is the loss caused by inflation and unemployment in each of the regions We

assume equal weights in the loss function The specific target of monetary

cooperation is to minimize the loss, given the inflation functions and the

unemployment functions Taking account of equations (1), (2), (3) and (4), the

loss function under monetary cooperation can be written as follows:

M Carlberg, Monetary and Fiscal Strategies in the World Economy, 94

DOI 10.1007/978-3-642-10476-3_13, © Springer-Verlag Berlin Heidelberg 2010

Equation (7) shows the first-order condition with respect to European money

supply And equation (8) shows the first-order condition with respect to

American money supply

The cooperative equilibrium is determined by the first-order conditions for a

minimum loss The solution to this problem is as follows:

Equations (9) and (10) show the cooperative equilibrium of European money

supply and American money supply As a result there is a unique cooperative

equilibrium An increase in A1 causes an increase in both European and

American money supply Obviously, the cooperative equilibrium is identical to

the corresponding Nash equilibrium That is to say, monetary cooperation case B

is equivalent to monetary interaction case B For some numerical examples see

Chapter 2

Monetary Cooperation between Europe and America: Case B

96

Chapter 6

Monetary Cooperation

between Europe and America: Case C

The model of unemployment and inflation can be characterized by a system

The policy makers are the European central bank and the American central

bank The targets of monetary cooperation are zero inflation in Europe, zero

inflation in America, and zero unemployment in America The instruments of

monetary cooperation are European money supply and American money supply

There are three targets but only two instruments, so what is needed is a loss

function We assume that the European central bank and the American central

bank agree on a common loss function:

L is the loss caused by inflation in Europe, inflation in America, and

unemployment in America We assume equal weights in the loss function The

specific target of monetary cooperation is to minimize the loss, given the

inflation functions and the unemployment function Taking account of equations

(2), (3) and (4), the loss function under monetary cooperation can be written as

follows:

M Carlberg, Monetary and Fiscal Strategies in the World Economy, 96

DOI 10.1007/978-3-642-10476-3_14, © Springer-Verlag Berlin Heidelberg 2010

Equation (7) shows the first-order condition with respect to European money

supply And equation (8) shows the first-order condition with respect to

American money supply

The cooperative equilibrium is determined by the first-order conditions for a

minimum loss The solution to this problem is as follows:

Equations (9) and (10) show the cooperative equilibrium of European money

supply and American money supply As a result there is a unique cooperative

equilibrium Obviously, the cooperative equilibrium is identical to the

corresponding Nash equilibrium That is to say, monetary cooperation case C is

equivalent to monetary interaction case C For some numerical examples see

Chapter 3

Monetary Cooperation between Europe and America: Case C

Part Four

Fiscal Policies

in Europe and America Absence of a Deficit Target

The world economy consists of two monetary regions, say Europe and

America The monetary regions are the same size and have the same behavioural

functions An increase in European government purchases lowers European

unemployment On the other hand, it raises European inflation Correspondingly,

an increase in American government purchases lowers American unemployment

On the other hand, it raises American inflation An essential point is that fiscal

policy in Europe has spillover effects on America and vice versa An increase in

European government purchases lowers American unemployment and raises

American inflation Similarly, an increase in American government purchases

lowers European unemployment and raises European inflation

The model of unemployment and inflation can be represented by a system of

Here u1 denotes the rate of unemployment in Europe, u2 is the rate of

unemployment in America, π is the rate of inflation in Europe, 1 π is the rate of 2

inflation in America, G1 is European government purchases, G2 is American

government purchases, A1 is some other factors bearing on the rate of

unemployment in Europe, A2 is some other factors bearing on the rate of

unemployment in America, B1 is some other factors bearing on the rate of

inflation in Europe, and B2 is some other factors bearing on the rate of inflation

M Carlberg, Monetary and Fiscal Strategies in the World Economy, 101

DOI 10.1007/978-3-642-10476-3_15, © Springer-Verlag Berlin Heidelberg 2010

of American government purchases, and a positive function of European government purchases

Now consider the direct effects According to the model, an increase in European government purchases lowers European unemployment On the other hand, it raises European inflation Correspondingly, an increase in American government purchases lowers American unemployment On the other hand, it raises American inflation Then consider the spillover effects According to the model, an increase in European government purchases lowers American unemployment and raises American inflation Similarly, an increase in American government purchases lowers European unemployment and raises European inflation

According to the model, a unit increase in European government purchases lowers European unemployment by 1 percentage point On the other hand, it raises European inflation by 1 percentage point And what is more, a unit increase in European government purchases lowers American unemployment by 0.5 percentage points and raises American inflation by 0.5 percentage points For instance, let European unemployment be 2 percent, and let European inflation be

2 percent as well Further, let American unemployment be 2 percent, and let American inflation be 2 percent as well Now consider a unit increase in European government purchases Then European unemployment goes from 2 to

1 percent On the other hand, European inflation goes from 2 to 3 percent And

Fiscal Interaction between Europe and America

what is more, American unemployment goes from 2 to 1.5 percent, and

American inflation goes from 2 to 2.5 percent

The target of the European government is zero unemployment in Europe

The instrument of the European government is European government purchases

By equation (1), the reaction function of the European government is:

Suppose the American government raises American government purchases

Then, as a response, the European government lowers European government

purchases

The target of the American government is zero unemployment in America

The instrument of the American government is American government purchases

By equation (2), the reaction function of the American government is:

Suppose the European government raises European government purchases Then,

as a response, the American government lowers American government

purchases

The Nash equilibrium is determined by the reaction functions of the

European government and the American government The solution to this

Equations (7) and (8) show the Nash equilibrium of European government

purchases and American government purchases As a result there is a unique

Nash equilibrium According to equations (7) and (8), an increase in A1 causes

an increase in European government purchases and a decline in American

government purchases A unit increase in A1 causes an increase in European

government purchases of 1.33 units and a decline in American government

1 The Model

104

purchases of 0.67 units As a result, given a shock, fiscal interaction produces

zero unemployment in Europe and America

2 Some Numerical Examples

For easy reference, the basic model is summarized here:

It proves useful to study six distinct cases:

- a demand shock in Europe

- a supply shock in Europe

- a mixed shock in Europe

- another mixed shock in Europe

- a common demand shock

- a common supply shock

1) A demand shock in Europe In each of the regions, let initial

unemployment be zero, and let initial inflation be zero as well Step one refers to

a decline in the demand for European goods In terms of the model there is an

increase in A1 of 3 units and a decline in B1 of equally 3 units Step two refers

Fiscal Interaction between Europe and America