Monetary policy strategies in the world economy carlberg_8 docx

As a result, given a demand shock in Europe, monetary and fiscal cooperation produces zero inflation, zero unemployment, and a zero structural deficit in each of the regions.. Table 7.19

unemployment functions, and the structural deficit functions Taking account of

equations (1) to (6), the loss function under policy cooperation can be written as

Equation (9) shows the first-order condition with respect to European money

supply Equation (10) shows the first-order condition with respect to American

money supply Equation (11) shows the first-order condition with respect to

European government purchases And equation (12) shows the first-order

condition with respect to American government purchases

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

minimum loss We assume T T= 1=T2 The solution to this problem is as

Equations (13) to (16) show the cooperative equilibrium of European money supply, American money supply, European government purchases, and American government purchases As a result there is a unique cooperative equilibrium An increase in A1 causes an increase in European money supply, an increase in American money supply, no change in European government purchases, and no change in American government purchases A unit increase in A1 causes an increase in European money supply of 0.67 units and an increase in American money supply of 0.33 units

As a result, monetary and fiscal cooperation can reduce the loss caused by inflation, unemployment, and the structural deficit Monetary and fiscal cooperation is different from monetary and fiscal interaction This applies to cases A, B and C of monetary and fiscal interaction, see Part Seven On the other hand, monetary and fiscal cooperation is equivalent to pure monetary cooperation

of type B And what is more, monetary and fiscal cooperation is equivalent to pure monetary interaction of type B, see Part Three

2 Some Numerical Examples

It proves useful to study eight 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

- a common mixed shock

- another common mixed shock

1) A demand shock in Europe In each of the regions, let initial unemployment be zero, let initial inflation be zero, and let the initial structural deficit 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 1

B of equally 3 units Step two refers to the outside lag Unemployment in Europe goes from zero to 3 percent Unemployment in America stays at zero percent Inflation in Europe goes from zero to – 3 percent Inflation in America stays at zero percent The structural deficit in Europe stays at zero percent, as does the structural deficit in America

Step three refers to the policy response What is needed, according to the model, is an increase in European money supply of 4 units, an increase in American money supply of 2 units, no change in European government purchases, and no change in American government purchases Step four refers to the outside lag Unemployment in Europe goes from 3 to zero percent Unemployment in America stays at zero percent Inflation in Europe goes from –

3 to zero percent Inflation in America stays at zero percent The structural deficit

in Europe stays at zero percent, as does the structural deficit in America For a synopsis see Table 7.19

As a result, given a demand shock in Europe, monetary and fiscal cooperation produces zero inflation, zero unemployment, and a zero structural deficit in each of the regions The loss function under policy cooperation is:

2 2 2 2 2 2

The initial loss is zero The demand shock in Europe causes a loss of 18 units

Then policy cooperation brings the loss down to zero again

Table 7.19

Monetary and Fiscal Cooperation between Europe and America

A Demand Shock in Europe

Change in Money Supply 4 Change in Money Supply 2

Change in Govt Purchases 0 Change in Govt Purchases 0

2) A supply shock in Europe In each of the regions let initial unemployment

be zero, let initial inflation be zero, and let the initial structural deficit be zero as

well Step one refers to the supply shock in Europe In terms of the model there is

an increase in B1 of 3 units and an increase in A1 of equally 3 units Step two

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

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

percent And unemployment in America stays at zero percent

Step three refers to the policy response What is needed, according to the

model, is no change in European money supply, no change in American money

supply, no change in European government purchases, and no change in

American government purchases Step four refers to the outside lag Inflation in

Europe stays at 3 percent Inflation in America stays at zero percent

Unemployment in Europe stays at 3 percent Unemployment in America stays at

zero percent The structural deficit in Europe stays at zero percent, as does the

structural deficit in America For an overview see Table 7.20

As a result, given a supply shock in Europe, monetary and fiscal cooperation

is ineffective The initial loss is zero The supply shock in Europe causes a loss of

18 units Then policy cooperation keeps the loss at 18 units

Table 7.20

Monetary and Fiscal Cooperation between Europe and America

A Supply Shock in Europe

Change in Money Supply 0 Change in Money Supply 0

Change in Govt Purchases 0 Change in Govt Purchases 0

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

be zero, let initial inflation be zero, and let the initial structural deficit be zero as well Step one refers to the mixed shock in Europe In terms of the model there is

an increase in B1 of 6 units Step two refers to the outside lag Inflation in Europe goes from zero to 6 percent Inflation in America stays at zero percent Unemployment in Europe stays at zero percent, as does unemployment in America

Step three refers to the policy response What is needed, according to the model, is a reduction in European money supply of 4 units, a reduction in American money supply of 2 units, no change in European government purchases, and no change in American government purchases Step four refers to the outside lag Inflation in Europe goes from 6 to 3 percent Inflation in America stays at zero percent Unemployment in Europe goes from zero to 3 percent Unemployment in America stays at zero percent The structural deficit in Europe stays at zero percent, as does the structural deficit in America Table 7.21 presents a synopsis

First consider the effects on Europe As a result, given a mixed shock in Europe, monetary and fiscal cooperation lowers inflation in Europe On the other hand, it raises unemployment there And what is more, it produces a zero structural deficit Second consider the effects on America As a result, monetary and fiscal cooperation produces zero inflation, zero unemployment, and a zero structural deficit in America The initial loss is zero The mixed shock in Europe causes a loss of 36 units Then policy cooperation brings the loss down to 18 units

Table 7.21

Monetary and Fiscal Cooperation between Europe and America

A Mixed Shock in Europe

Change in Money Supply − 4 Change in Money Supply − 2

Change in Govt Purchases 0 Change in Govt Purchases 0

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

unemployment be zero, let initial inflation be zero, and let the initial structural

deficit be zero as well Step one refers to the mixed shock in Europe In terms of

the model there is an increase in A1 of 6 units Step two refers to the outside lag

Unemployment in Europe goes from zero to 6 percent Unemployment in

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

inflation in America

Step three refers to the policy response What is needed, according to the

model, is an increase in European money supply of 4 units, an increase in

American money supply of 2 units, no change in European government

purchases, and no change in American government purchases Step four refers to

the outside lag Unemployment in Europe goes from 6 to 3 percent

Unemployment in America stays at zero percent Inflation in Europe goes from

zero to 3 percent Inflation in America stays at zero percent The structural deficit

in Europe stays at zero percent, as does the structural deficit in America Table

7.22 gives an overview

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

in Europe, monetary and fiscal cooperation lowers unemployment in Europe On

the other hand, it raises inflation there And what is more, it produces a zero

structural deficit Second consider the effects on America As a result, monetary

and fiscal cooperation produces zero inflation, zero unemployment, and a zero

structural deficit in America The initial loss is zero The mixed shock in Europe

causes a loss of 36 units Then policy cooperation brings the loss down to 18

units

Table 7.22

Monetary and Fiscal Cooperation between Europe and America

Another Mixed Shock in Europe

Change in Money Supply 4 Change in Money Supply 2

Change in Govt Purchases 0 Change in Govt Purchases 0

5) A common demand shock In each of the regions, let initial unemployment

be zero, let initial inflation be zero, and let the initial structural deficit be zero as well Step one refers to a decline in the demand for European and American goods In terms of the model there is an increase in A1 of 3 units, a decline in B1

of 3 units, an increase in A2 of 3 units, and a decline in B2 of 3 units Step two refers to the outside lag Unemployment in Europe goes from zero to 3 percent,

as does unemployment in America Inflation in Europe goes from zero to – 3 percent, as does inflation in America

Step three refers to the policy response What is needed, according to the model, is an increase in European money supply of 6 units, an increase in American money supply of 6 units, no change in European government purchases, and no change in American government purchases Step four refers to the outside lag Unemployment in Europe goes from 3 to zero percent, as does unemployment in America Inflation in Europe goes from – 3 to zero percent, as does inflation in America And the structural deficit in Europe stays at zero percent, as does the structural deficit in America For a synopsis see Table 7.23

As a result, given a common demand shock, monetary and fiscal cooperation achieves zero inflation, zero unemployment, and a zero structural deficit in each

of the regions The initial loss is zero The common demand shock causes a loss

of 36 units Then policy cooperation brings the loss down to zero again

Table 7.23

Monetary and Fiscal Cooperation between Europe and America

A Common Demand Shock

Change in Money Supply 6 Change in Money Supply 6

Change in Govt Purchases 0 Change in Govt Purchases 0

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

be zero, let initial inflation be zero, and let the initial structural deficit 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 What is needed, according to the

model, is no change in European money supply, no change in American money

supply, no change in European government purchases, and no change in

American government purchases Step four refers to the outside lag Inflation in

Europe stays at 3 percent, as does inflation in America Unemployment in

Europe stays at 3 percent, as does unemployment in America The structural

deficit in Europe stays at zero percent, as does the structural deficit in America

For an overview see Table 7.24

As a result, given a common supply shock, monetary and fiscal cooperation

is ineffective The initial loss is zero The common supply shock causes a loss of

36 units Then policy cooperation keeps the loss at 36 units

Table 7.24

Monetary and Fiscal Cooperation between Europe and America

A Common Supply Shock

Change in Money Supply 0 Change in Money Supply 0

Change in Govt Purchases 0 Change in Govt Purchases 0

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

be zero, let initial inflation be zero, and let the initial structural deficit 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 What is needed, according to the

model, is a reduction in European money supply of 6 units, a reduction in

American money supply of 6 units, no change in European government

purchases, and no change in American government purchases Step four refers to

the outside lag Inflation in Europe goes from 6 to 3 percent, as does inflation in

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

unemployment in America The structural deficit in Europe stays at zero percent,

as does the structural deficit in America Table 7.25 presents a synopsis

Table 7.25

Monetary and Fiscal Cooperation between Europe and America

A Common Mixed Shock

Change in Money Supply − 6 Change in Money Supply − 6

Change in Govt Purchases 0 Change in Govt Purchases 0

As a result, given a common mixed shock, monetary and fiscal cooperation lowers inflation On the other hand, it raises unemployment And what is more, it produces zero structural deficits The initial loss is zero The common mixed shock causes a loss of 72 units Then policy cooperation brings the loss down to

36 units

8) Another common mixed shock In each of the regions, let initial unemployment be zero, let initial inflation be zero, and let the initial structural deficit 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 What is needed, according to the model, is an increase in European money supply of 6 units, an increase in American money supply of 6 units, no change in European government purchases, and no change in American government purchases Step four refers to the outside lag Unemployment in Europe goes from 6 to 3 percent, as does unemployment in America Inflation in Europe goes from zero to 3 percent, as does inflation in America And the structural deficit in Europe stays at zero percent, as does the structural deficit in America Table 7.26 gives an overview

As a result, given another common mixed shock, monetary and fiscal cooperation lowers unemployment On the other hand, it raises inflation And what is more, it produces zero structural deficits The initial loss is zero The common mixed shock causes a loss of 72 units Then policy cooperation brings the loss down to 36 units

Table 7.26

Monetary and Fiscal Cooperation between Europe and America

Another Common Mixed Shock

Change in Money Supply 6 Change in Money Supply 6

Change in Govt Purchases 0 Change in Govt Purchases 0

9) Summary Given a demand shock in Europe, policy cooperation achieves

zero inflation, zero unemployment, and a zero structural deficit in each of the

regions Given a supply shock in Europe, policy cooperation is ineffective Given

a mixed shock in Europe, policy cooperation lowers inflation in Europe On the

other hand, it raises unemployment there And what is more, it produces a zero

structural deficit Given another type of mixed shock in Europe, policy

cooperation lowers unemployment in Europe On the other hand, it raises

inflation there And what is more, it produces a zero structural deficit

10) Comparing policy cooperation with other regimes First, monetary and

fiscal cooperation is equivalent to pure monetary cooperation of type B, see Part

Three Second, monetary and fiscal cooperation is equivalent to pure monetary

interaction of type B, see Part Three Third, monetary and fiscal cooperation is superior to monetary and fiscal interaction of type B, see Part Seven