Fiscal and Monetary Policies in a Monetary Union: Conflict or Cooperation?

Abstract

In this paper we present an application of the dynamic tracking games framework to a monetary union. We use a small stylized nonlinear two-country macroeconomic model (MUMOD1) of a monetary union to analyse the interactions between fiscal (governments) and monetary (common central bank) policy makers, assuming different objective functions of these decision makers. Using the OPTGAME algorithm we calculate solutions for two game strategies: a cooperative solution (Pareto optimal) and a non-cooperative equilibrium solution (the Nash game for the feedback information pattern). We show how the policy makers react to demand shocks under non-cooperation and cooperation scenarios. The cooperative solution dominates the non-cooperative solution in all scenarios, which may be interpreted as an argument for coordinating fiscal and monetary policies in a monetary union in a situation of high public debt such as in the recent sovereign debt crisis in Europe.