Monetary and Fiscal Strategies in the World Economy by Michael Carlberg_8 doc

An increase in European government purchases lowers American unemployment and raises American inflation.. Similarly, an increase in American government purchases lowers European unemploy

2.2 Fiscal Cooperation between Europe and America

The policy makers are the European government and the American government The targets of fiscal cooperation are zero unemployment in Europe and America The instruments of fiscal cooperation are European government purchases and American government purchases There are two targets and two instruments We assume that the European government and the American

government agree on a common loss function The amount of loss depends on

unemployment in Europe and America The policy makers set European government purchases and American government purchases so as to minimize the common loss

The cooperative equilibrium is determined by the first-order conditions for a minimum loss It yields the optimum levels of European government purchases and American government purchases As a result, the cooperative equilibrium is identical to the corresponding Nash equilibrium That is to say, fiscal cooperation

is equivalent to fiscal interaction For some numerical examples see Section 2.1

3 Fiscal Policies in Europe and America:

Presence of a Deficit Target

3.1 Fiscal Interaction between Europe and America

1) The model An increase in European government purchases lowers

European unemployment On the other hand, it raises European inflation And what is more, it raises the European structural deficit Correspondingly, an increase in American government purchases lowers American unemployment

On the other hand, it raises American inflation And what is more, it raises the American structural deficit 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

In the numerical example, 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, it raises the European structural deficit by 1 percentage point A unit increase in European government purchases lowers American unemployment by 0.5 percentage points and raises American inflation by 0.5 percentage points However, it has no effect

on the American structural deficit

For instance, let European unemployment be 2 percent, let European inflation be 2 percent, and let the European structural deficit be 2 percent as well Further, let American unemployment be 2 percent, let American inflation be 2 percent, and let the American structural deficit be 2 percent as well Now consider a unit increase in European government purchases Then European unemployment goes from 2 to 1 percent European inflation goes from 2 to 3 percent And the European structural deficit goes from 2 to 3 percent as well American unemployment goes from 2 to 1.5 percent American inflation goes from 2 to 2.5 percent And the American structural deficit stays at 2 percent

The targets of the European government are zero unemployment and a zero structural deficit in Europe The instrument of the European government is European government purchases There are two targets but only one instrument,

so what is needed is a loss function We assume that the European government has a quadratic loss function The amount of loss depends on unemployment and the structural deficit in Europe The European government sets European government purchases so as to minimize its loss From this follows the reaction function of the European government Suppose the American government raises American government purchases Then, as a response, the European government lowers European government purchases

The targets of the American government are zero unemployment and a zero structural deficit in America The instrument of the American government is American government purchases There are two targets but only one instrument,

so what is needed is a loss function We assume that the American government has a quadratic loss function The amount of loss depends on unemployment and the structural deficit in America The American government sets American government purchases so as to minimize its loss From this follows the reaction function of the American government 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 It yields the equilibrium levels of European government purchases and American government purchases

As a rule, unemployment in Europe and America is not zero And the structural deficits in Europe and America are not zero either

2) A demand shock in Europe We assume equal weights in each of the loss functions Let initial unemployment in Europe be 3 percent, and let initial unemployment in America be zero percent Let initial inflation in Europe be – 3 percent, and let initial inflation in America be zero percent Let the initial structural deficit in Europe be zero percent, and let the initial structural deficit in America be the same

Step one refers to the policy response According to the Nash equilibrium there is an increase in European government purchases of 1.6 units and a

reduction in American government purchases of 0.4 units Step two refers to the outside lag Unemployment in Europe goes from 3 to 1.6 percent Unemployment in America goes from zero to – 0.4 percent Inflation in Europe goes from – 3 to – 1.6 percent Inflation in America goes from zero to 0.4 percent The structural deficit in Europe goes from zero to 1.6 percent And the structural deficit in America goes from zero to – 0.4 percent For a synopsis see Table 9.7

Table 9.7

Fiscal Interaction between Europe and America

A Demand Shock in Europe

Europe America

Unemployment 3 Unemployment 0

Inflation − 3 Inflation 0 Structural Deficit 0 Structural Deficit 0 Change in Govt Purchases 1.6 Change in Govt Purchases − 0.4 Unemployment 1.6 Unemployment − 0.4 Inflation − 1.6 Inflation 0.4 Structural Deficit 1.6 Structural Deficit − 0.4

First consider the effects on Europe As a result, given a demand shock in Europe, fiscal interaction lowers unemployment and deflation in Europe On the other hand, it raises the structural deficit there Second consider the effects on America As a result, fiscal interaction produces overemployment and inflation in America And what is more, it produces a structural surplus there

3.2 Fiscal Cooperation between Europe and America

1) The model The policy makers are the European government and the American government The targets of fiscal cooperation are zero unemployment and a zero structural deficit in each of the regions The instruments of fiscal cooperation are European government purchases and American government purchases There are four targets but only two instruments, so what is needed is a loss function We assume that the European government and the American government agree on a common loss function The amount of loss depends on unemployment and the structural deficit in each of the regions The policy makers set European government purchases and American government purchases

so as to minimize the common loss

The cooperative equilibrium is determined by the first-order conditions for a minimum loss It yields the optimum levels of European government purchases and American government purchases

2) A demand shock in Europe We assume equal weights in the loss function Let initial unemployment in Europe be 3 percent, and let initial unemployment in America be zero percent Let initial inflation in Europe be – 3 percent, and let initial inflation in America be zero percent Let the initial structural deficit in Europe be zero percent, and let the initial structural deficit in America be the same

Step one refers to the policy response What is needed, according to the model, is an increase in European government purchases of 1.29 units and an increase in American government purchases of 0.09 units Step two refers to the outside lag Unemployment in Europe goes from 3 to 1.66 percent Unemployment in America goes from zero to – 0.74 percent Inflation in Europe goes from – 3 to – 1.66 percent Inflation in America goes from zero to 0.74 percent The structural deficit in Europe goes from zero to 1.29 percent And the structural deficit in America goes from zero to 0.09 percent For an overview see Table 9.8

First consider the effects on Europe As a result, given a demand shock in Europe, fiscal cooperation lowers unemployment and deflation in Europe On the other hand, it raises the structural deficit there Second consider the effects on America As a result, fiscal cooperation produces overemployment and inflation

in America And what is more, it produces a structural deficit there

Table 9.8

Fiscal Cooperation between Europe and America

A Demand Shock in Europe

Europe America

Unemployment 3 Unemployment 0 Inflation − 3 Inflation 0 Structural Deficit 0 Structural Deficit 0 Change in Govt Purchases 1.29 Change in Govt Purchases 0.09 Unemployment 1.66 Unemployment − 0.74 Inflation − 1.66 Inflation 0.74 Structural Deficit 1.29 Structural Deficit 0.09

3) Comparing fiscal interaction and fiscal cooperation As a result, the cooperative equilibrium is different from the Nash equilibrium In the numerical example, fiscal cooperation is superior to fiscal interaction

4 Monetary and Fiscal Policies in Europe and America: Absence of a Deficit Target

4.1 Monetary and Fiscal Interaction

between Europe and America

An increase in European money supply lowers European unemployment On the other hand, it raises European inflation Correspondingly, an increase in American money supply lowers American unemployment On the other hand, it raises American inflation An essential point is that monetary policy in Europe has spillover effects on America and vice versa An increase in European money supply raises American unemployment and lowers American inflation Similarly, an increase in American money supply raises European unemploy-ment and lowers European inflation

An increase in European government purchases lowers European ment On the other hand, it raises European inflation Correspondingly, an increase in American government purchases lowers American unemployment

unemploy-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

A unit increase in European money supply 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 money supply raises American unemployment by 0.5 percentage points and lowers American inflation by 0.5 percentage points 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

To illustrate this there are two numerical examples First consider an increase in European money supply.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 money supply Then European unemployment goes from 2 to 1 percent On the other hand, European inflation goes from 2 to 3 percent And what is more, American unemployment goes from 2 to 2.5 percent, and American inflation goes from 2 to 1.5 percent Second consider an increase in European government purchases 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 what is more, American unemployment goes from 2 to 1.5 percent, and American inflation goes from 2 to 2.5 percent

As to policy targets there are two distinct cases In case A the target of the European central bank is zero inflation in Europe The target of the American central bank is zero inflation in America The target of the European government

is zero unemployment in Europe And the target of the American government is zero unemployment in America In case B the targets of the European central bank are zero inflation and zero unemployment in Europe The targets of the American central bank are zero inflation and zero unemployment in America The target of the European government is zero unemployment in Europe And the target of the American government is zero unemployment in America

1) Case A The target of the European central bank is zero inflation in Europe The instrument of the European central bank is European money supply From this follows the reaction function of the European central bank Suppose the American central bank lowers American money supply Then, as a response, the European central bank lowers European money supply Suppose the European government raises European government purchases Then, as a response, the European central bank lowers European money supply Suppose the American government raises American government purchases Then, as a response, the European central bank lowers European money supply

The target of the American central bank is zero inflation in America The instrument of the American central bank is American money supply From this follows the reaction function of the American central bank The target of the European government is zero unemployment in Europe The instrument of the European government is European government purchases From this follows the reaction function of the European government The target of the American government is zero unemployment in America The instrument of the American government is American government purchases From this follows the reaction function of the American government Suppose the European central bank lowers European money supply Then, as a response, the European government raises European government purchases, the American central bank lowers American money supply, and the American government lowers American government purchases

The Nash equilibrium is determined by the reaction functions of the European central bank, the American central bank, the European government, and the American government As an important result, in case A, there is no Nash equilibrium

2) Case B The targets of the European central bank are zero inflation and zero unemployment in Europe The instrument of the European central bank is European money supply There are two targets but only one instrument, so what

is needed is a loss function We assume that the European central bank has a quadratic loss function The amount of loss depends on inflation and unemployment in Europe The European central bank sets European money supply so as to minimize its loss From this follows the reaction function of the European central bank

The targets of the American central bank are zero inflation and zero unemployment in America The instrument of the American central bank is American money supply There are two targets but only one instrument, so what

is needed is a loss function We assume that the American central bank has a quadratic loss function The amount of loss depends on inflation and unemployment in America The American central bank sets American money supply so as to minimize its loss From this follows the reaction function of the American central bank

The target of the European government is zero unemployment in Europe The instrument of the European government is European government purchases From this follows the reaction function of the European government The target

of the American government is zero unemployment in America The instrument

of the American government is American government purchases From this follows the reaction function of the American government

The Nash equilibrium is determined by the reaction functions of the European central bank, the American central bank, the European government, and the American government As an important result, in case B, there is no Nash equilibrium

4.2 Monetary and Fiscal Cooperation

between Europe and America

1) The model The policy makers are the European central bank, the American central bank, the European government, and the American government The targets of policy cooperation are zero inflation in Europe, zero inflation in America, zero unemployment in Europe, and zero unemployment in America The instruments of policy cooperation are European money supply, American money supply, European government purchases, and American government purchases There are four targets and four instruments We assume that the policy makers agree on a common loss function The amount of loss depends on inflation and unemployment in each of the regions The policy makers set European money supply, American money supply, European government purchases, and American government purchases so as to minimize the common loss

The cooperative equilibrium is determined by the first-order conditions for a minimum loss It yields the optimum levels of European money supply, American money supply, European government purchases, and American

government purchases As a result there is an infinite number of solutions Put

another way, monetary and fiscal cooperation can reduce the loss caused by

inflation and unemployment

2) A demand shock in Europe We assume equal weights in the loss

function Let initial unemployment in Europe be 3 percent, and let initial

unemployment in America be zero percent Let initial inflation in Europe be – 3

percent, and let initial inflation in America be zero percent Step one refers to the

policy response According to the model, a first solution 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 two 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 And inflation in

America stays at zero percent Table 9.9 presents a synopsis

Table 9.9

Monetary and Fiscal Cooperation between Europe and America

A Demand Shock in Europe

Europe America

Unemployment 3 Unemployment 0

Change in Money Supply 4 Change in Money Supply 2

Change in Govt Purchases 0 Change in Govt Purchases 0

A second solution is no change in European money supply, no change in

American money supply, an increase in European government purchases of 4

units, and a reduction in American government purchases of 2 units A third

solution is an increase in European money supply of 2 units, an increase in American money supply of 1 unit, an increase in European government purchases of 2 units, and a reduction in American government purchases of 1 unit As a result, given a demand shock in Europe, monetary and fiscal cooperation produces zero inflation and zero unemployment in each of the regions

3) A supply shock in Europe Let initial inflation in Europe be 3 percent, and let initial inflation in America be zero percent Let initial unemployment in Europe be 3 percent, and let initial unemployment in America be zero percent Step one refers to the policy response According to the model, a first solution 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 As a result, given a supply shock in Europe, monetary and fiscal cooperation is ineffective

4) A mixed shock in Europe Let initial inflation in Europe be 6 percent, and let initial inflation in America be zero percent Let initial unemployment in Europe be zero percent, and let initial unemployment in America be the same Step one refers to the policy response According to the model, a first solution 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 two 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 And unemployment in America stays at zero percent Table 9.10 gives an overview

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 Second consider the effects on America As

a result, monetary and fiscal cooperation produces zero inflation and zero unemployment in America

5) Comparing policy interaction and policy cooperation Under policy interaction there is no Nash equilibrium By contrast, under policy cooperation, the loss can be brought down That is to say, policy cooperation seems to be superior to policy interaction

Table 9.10

Monetary and Fiscal Cooperation between Europe and America

A Mixed Shock in Europe

Europe America

Unemployment 0 Unemployment 0

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

Change in Govt Purchases 0 Change in Govt Purchases 0

5 Monetary and Fiscal Policies in Europe and America: Presence of a Deficit Target

5.1 Monetary and Fiscal Interaction

between Europe and America: Case A

1) The model An increase in European money supply lowers European unemployment On the other hand, it raises European inflation Correspondingly,

an increase in American money supply lowers American unemployment On the other hand, it raises American inflation An essential point is that monetary policy in Europe has spillover effects on America and vice versa An increase in European money supply raises American unemployment and lowers American inflation Similarly, an increase in American money supply raises European unemployment and lowers European inflation

An increase in European government purchases lowers European ment On the other hand, it raises European inflation And what is more, it raises the European structural deficit Correspondingly, an increase in American government purchases lowers American unemployment On the other hand, it raises American inflation And what is more, it raises the American structural deficit 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

unemploy-A unit increase in European money supply lowers European unemployment

by 1 percentage point On the other hand, it raises European inflation by 1 percentage point Correspondingly, 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, it raises the European structural deficit by 1 percentage point As to the spillover effects, a unit increase in European money supply raises American unemploy-ment by 0.5 percentage points and lowers American inflation by 0.5 percentage

points Conversely, a unit increase in European government purchases lowers American unemployment by 0.5 percentage points and raises American inflation

Second consider an increase in European government purchases For instance, let European unemployment be 2 percent, let European inflation be 2 percent, and let the European structural deficit be 2 percent as well Further, let American unemployment be 2 percent, let American inflation be 2 percent, and let the American structural deficit 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 the European structural deficit goes from 2 to 3 percent as well What is more, American unemployment goes from 2 to 1.5 percent American inflation goes from 2 to 2.5 percent And the American structural deficit stays at

2 percent

As to policy targets there are two distinct cases In case A the target of the European central bank is zero inflation in Europe The target of the American central bank is zero inflation in America The targets of the European government are zero unemployment and a zero structural deficit in Europe And the targets of the American government are zero unemployment and a zero structural deficit in America

In case B the targets of the European central bank are zero inflation and zero unemployment in Europe The targets of the American central bank are zero