Strategic exchange rate co-ordination: A three-country model

Jae-Young Rhee

Abstract

The highly integrated nature of the global economy has increased the interdependence of macroeconomic policy between countries. The benefit of international policy co-ordination has been analyzed by many economists with optimal control and game theory techniques. In the literature, different assumptions regarding the strategic behavior of countries lead to several common equilibrium concepts as the available options to the policy authorities: Nash, Stackelberg, and cooperative equilibria. A cooperative solution generally has advantages over a non-cooperative Nash solution, and the difference is measured as the welfare gains from co-ordination. The advantages of a Stackelberg leader-follower solution over a Nash equilibrium are also often discussed. Some common features of existing studies are that money supply policy is used in pursuing two targets in a symmetric two-country model, and that mutual gains from coordination are suggested. Recently, however, numerical analyses find the gains from co-ordination to be small and sometimes negative. Thus, there have been attempts to find cases where co-ordination creates large gains. This thesis develops a Keynesian three-country model to extend this literature. Static game theory is used in short-run analysis. The exchange rate is strategically used by the stabilization policy authorities of two small countries as a monetary policy instrument, in pursuing three targets--the inflation rate, the balance of payments, and the employment rate. The third country, the rest of the world, is assumed to be passive. With these new features of our framework and with representative parameter values being used in numerical simulations, we investigate several suggestions made by other authors regarding the issue of gains from policy co-ordination. The links with the third country significantly influence the effects of the small countries' policies. Hence, the Canzoneri-Minford and Turnovsky-d'Orey suggestions that higher macroeconomic interdependence (measured as the ratio of transmission effects to own policy effects) between economies or lower trade price elasticities may increase the gains from co-ordination do not always hold. Tobin's (1978, p. 489) proposal that we should throw "some sand in the wheels of our excessively efficient international money markets" is examined under varying degrees of capital mobility, and it is supported by our findings. The effects of structural asymmetry between the small countries on the welfare outcome are also analyzed by allowing for asymmetric patterns in trade and capital flows. In some asymmetric patterns, one country is always better off as a Stackelberg leader, contrasting with the result of Eichengreen. The gains of both countries from policy co-ordination suggest stability of the co-ordination in these asymmetric patterns. However, the gains from co-ordination turn out to be small.