Macroeconomic Policies in a Monetary Union: A Dynamic Game

We develop a dynamic game model of a two-country monetary union to study strategic interactions between macroeconomic policy-makers facing adaptive inflationary expectations. In this union, governments of participating countries pursue national goals when deciding about fiscal policies, whereas the common central bank’s monetary policy aims at union-wide objectives. For a symmetric demand shock, we derive numerical solutions of the dynamic game between the governments and the central bank, using the OPTGAME algorithm (Behrens and Neck, 2003a). Different solution concepts for this game serve as models of a conflict between national and supra-national institutions (non-cooperative Nash equilibrium) on the one hand and of coordinated policy-making (cooperative Pareto solutions) on the other. We show that the volatility of output and inflation increase when actual inflation reacts more strongly to expected inflation. Moreover, there is a trade-off between instruments’ and targets’ deviations from desired paths.