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If each fiscal authority has its own region, it can use fiscal policy to increase NGDP for its own region, while recognising that the ECB will ensure that NGDP for the Eurozone as a whole is where the ECB wants it to be.

It's not done though, right? We need another game theoretic framework among Eurozone fiscal authorities. They all know the ECB will create X NGDP. They also know other fiscal authorities will somehow jockey for their preferred relative NGDP position and thus their absolute NGDP given X, but they all cannot maximize their relative position. Which fiscal authority acts last? This gets much more complicated when the fiscal authorities have varying NGDP preferences.

dlr: "This gets much more complicated when the fiscal authorities have varying NGDP preferences."

True. But I think it would be a fairly straightforward extension of the model to build that in. For example, if we use lowercase for individual countries, and uppercase for the Eurozone as a whole, the AD function could be something like:

n = N + a(f-F) = M + F + a(f-F) (with everything normalised to keep it simple, so we don't have to keep multiplying and dividing by 28).

Then solve for each country's reaction function.

"Which fiscal authority acts last?"

What matters is that they won't all move first, before the ECB moves. I would model it as all 29 (the 28 plus the ECB) moving simultaneously.

But the Eurozone was not always a mess, it seemed to be working for a while. It was only when a monetary shock hit that things went bad. (Taking the GFC as not being the problem, but the unrequited upward shift in monetary demand it created being the problem.)

Lorenzo: good critique!

*If* this model is right, we would have to explain it as follows: for a long time, N*m and N*f were equal to each other, so the simultaneous Nash equilibrium was at the bliss point, and all was well with the Eurozone. Then *for some reason*, M*m fell relative to N*f, and we got the bad equilibrium shown above.


How do the players know when the game ends? If the game does not end, who moves last?

But the Euro was a predictable mess, wasn't it?

And what about the USA, with 50 state fiscal authorities and one federal fiscal authority? Why isn't it as much of a mess as the Eurozone?

Min: the easiest way to think about it: the game is only played once. But before the game begins, the fiscal authority decides whether to move first, or whether they will move simultaneously.

Maybe because there is greater labour mobility in the US.

Yes, it is plausible. Especially if we take it that, in entering the Eurozone, the fiscal authorities were setting N*f so as to conform to the requisite monetary setting. So, they were at a "bliss point". The problem was dealing with shock(s), when coordination broke down (somewhat predictably).
Of course, if Tom Sargent is correct, they were not as much on it as it appeared.

On the "why not the US?" question, lots of US states have balanced budget amendments, which suggest not much in the way of fiscal "movement". Also, federal spending provides a stabiliser and labour mobility is, indeed, higher. Both Krugman, in his discussion of OCA's revenge,
and Sargent, in his Nobel Memorial Lecture, have discussed this, though Sargent more about the early history of the US.

Nick Rowe: "the easiest way to think about it: the game is only played once."

Well, as we have known for more than 30 years, iterated games can have different qualities from single games, and that seems likely to be the case here.

Min: suppose we literally have a one-shot game. And suppose the monetary and fiscal players literally must move at the same time. Then it would be impossible for a normal country to escape the simultaneous Nash equilibrium.

But in a repeated game, the fiscal authority in a normal country could invest in a reputation for acting like a Stackelberg leader. It could cheat once, by playing simultaneous Nash, but then the monetary authority would not trust it again. So a normal country could escape the simultaneous Nash equilibrium, in a repeated game, even if the moves in each round of the game are literally simultaneous. But in the Eurozone there is a free-rider problem, since the monetary authority responds only to the average fiscal policy. So it can't escape simultaneous Nash.

That's the other way to look at it.

Excellent blog and also good point by Lorenzo. For me this is just another way of saying why fiscal transfers may play important role in any optimal currency area. Or why in such a circumstances it is good if central bank has sufficiently large NGDP goal so that the situation wher CB wants smaller NGDP than particular fiscal authority is less likely to arise.

So to sum it up - the best course of action for Europe is strong fiscal discipline rules accompanied by easier monetary policy acompanied by some sort of fiscal transfer policy in case of very large asymmetric shock.

JV: thanks!

Definitely easier (and better) monetary policy. I'm not sure about the fiscal "discipline" bit, because running large deficits isn't *always* undisciplined. It's hard to distinguish deficits run for micro grounds, from deficits that are run because monetary policy isn't what it should be and fiscal/monetary coordination problems.

Breaking up the Eurozone would be better, I think.

This where "CB independance" leads us: instead of having clear messages about a common goal, a guessing game. CB independance, in the sense of oacting as a separate unit from fiscal authorities is not needed in the competent countries west of the 1054 schism borders. And impossible anyway elsewhere ( why would the CB be more competent that the fisacal authority?
Which is why I always taught my students that, monetarily, what Canada and Québec needed wasn't two countries with the same currency but one country with two (or more ) currencies, coordinated by the same CB.
"Oh what fun it is to ride in a wild horses open sleigh..."

Jacques Rene: I think the problem is not CB independence, but fake independence. True independence is you let the CB control aggregate demand (NGDP, inflation, whatever) and don't try to use fiscal policy as well as monetary policy to control AD. The fiscal authority ignores AD. Fake independence is like when you tell your kids they are financially independent and must make their own earning and spending decisions, but keep on bailing them out.

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