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Monetary and fiscal policy in an open economy with or without policy coordination
European Economic Review 33 (1989) 303-309. North-Holland
International Economics
MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY WITH OR WITHOUT POLICY COORDINATION
Daniel COHEN CEPREMAP, 75103, Paris, France and CEPR, London, UK
1. Introduction
The well publicized Plaza and Louvre agreements arguably set monetary policies in the G7 countries into a cooperative path aimed at stabilizing the six exchange rates of the seven richest industrialized countries. The crash of October 1987 shed a cold shower on these agreements. Critics have argued that coordinating monetary policies without also coordinating Escal policies makes no sense to the extent that fiscal policies are the ultimate ‘real’phenomenon that governments should take care of. By failing to trigger the fiscal corrections needed to bring the world balance of payments back into a sustainable path, agreements such as those taken in the Plaza or in the Louvre could only gain time and make harder the fall that would follow. The issue of whether fiscal policy coordination is a necessary correlate to monetary policy coordination is of obvious importance to the question of whether monetary agreements such as the EMS are intrinsically good or bad, and even more crucially it is a question which lies at the heart.of monetary integration in Europe [see de Grauwe (1986)]. If a European Central Bank were to be created, substituting a European currency to those circulating nowadays, should it impose fiscal cooperation on the member countries? If the answer to this question were to be a yes, it would cast a doubt on the feasibility of monetary integration. Fiscal policies are extremely costly to modify, much more than monetary policies are. They are the result of complex compromise between the executive and the legislative branches, their margins of maneuvers are notoriously narrow, and it is difftcult to imagine how two parliaments could consistently coordinate their decisions. Yet the example of national monetary integration shows that fiscal 001~2921/89/$3.50 @IJI 1989, Elscvier Science Publishers B.V. (North-Holland)
304
D. Cohen, Monetary andfiscal policy in an open economy
coordination of the member states (say of America) is not a prerequisite. Indeed no explicit mechanism imposes on Massachusetts to coordinate its fiscal policy with that of Indiana. Then, to return to the doubts expressed about the Louvre and Plaza agreements, what can be wrong in coordinating monetary policies alone? The view taken in this paper comes as follows. Monetary policy coordination alone is acceptable only if it is credible. Under this condition, it will by itself trigger the appropriate fiscal correction needed to make it sustainable. Explicit fiscal coordination may well be welfare enhancing, but it is not a prerequisite and it is an issue which should not be confused with that of setting each fiscal policy on a path which is consistent with a collectively accepted monetary policy. The failure of the U.S. fiscal policy to respond to the Plaza and Louvre agreements should not be viewed as an unavoidable feature which forecloses any monetary policy coordination. Instead it should be viewed as an endogeneous feature which reflects the fact that these agreement lacked the credibility which could have imposed on the U.S. congressmen the task of taking the appropriate fiscal corrections. In the case of a monetary integration of Europe, one by which monetary policy across the member states is necessarily identical (henceforth one for which the credibility issue cannot arise), each member state will necessarily take the fiscal action that is needed and one should not fear that observed fiscal inertia will be translated into ex-post fiscal irresponsibility. To illustrate these points, the model presented in this paper will show how a non-cooperativeequilibrium between two countries may induce each country to pursue a self-defeating monetary policy (by which each country tries to devalue its currency vis-a-vis the other) accompanied by no fiscal stimulusat all. On the other hand, a cooperative equilibrium will freeze monetary policy and, in that case, fiscal policies alone will be triggered in each country. In brief, the policy mix which is adopted by each country always takes an extreme form: when the equilibrium is a non-cooperative one, only monetary policy is manipulated; when the equilibrium is a cooperative one, only fiscal policy is used. The reason why (in the model which is presented) is straightforward: fiscal policy is costly (it has a distortionary bias) while monetary policy has a beggar-my-neighbor component (through the exchange rate). Any non-cooperative equilibrium will induce a government to manipulate monetary policy alone in order to export the cost of its adjustment abroad. It takes a credible monetary agrement to induce the government to resort to their distortionary domestic policy instruments. 2. The model
I will assume that the world is composed of two identical countries. All starred variables will refer to the foreign country, non-starred variables to the
D. Coheb Monetary andjiscal policy in an open economy
305
domestic country. Because of this symmetry, I will describe the domestic economy only. 2.1. Supply The model is a version of Taylor (1979) staggered wage contract model. Wages are negotiated every two periods, and I will assume that wage earners have an average real reservation wage which is a constant. Wages negotiated at time t are set according to (1)
(all small letters are logarithms; the wage units are normalized so as to let the reservation wage to be equal to 1). Firms’ prices are set according to a mark-up about average cost
(2) 2.2. Demand I will assume that demand is driven by two components: foreign demand and government spending
Y,= e,r, + &g,,
(3)
in which z, is the real exchange rate z,=e,+p,-p:.
(4)
e, is the nominal exchange rate. Demand here is extremely unsophisticated and no intertemporal substitution is taken into account. (In particular 8i may be viewed as a balancebudget multiplier in order to account for the government’s budget constraint). I will assume that only one good is sold home and abroad, but that trade is costly and that &,z, measures the response on demand of a price differential between the two countries. 2.3. Money demand Here again a simplified version is postulated: m, = P,- Ai,,
(5)
in which i, is the nominal interest rate and m, is the logarithm of money suPPlY*
D. Cohen, Monetary
306
andfical
policy
in an open
economy
2.4. Exchange rate I will assume that the uncovered interest rate arbitrage holds: i,=i:+E,(e,+,-e,).
(6)
2.5. Government 3 preferences The government form
tries to minimise an intertemporal
loss function of the
in which ~,=p~-p~_~ is the current inflation rate, and j( >O) is a government’s target for output. When j=O, each government can attain it first best by setting m =m: =0 and gt=g: =O. When JJ and j* are strictly positive some action will be undertaken and the outcome will depend crucially upon the set of strategies each government has access to. I will distinguish four types of equilibria: Non-cooperative and cooperative ones, on the one hand, reputational and non-reputational equilibria on the other hand. 3. Non-cooperative equilibria 3.1. With intertemporal commitment of the government I will assume, here, that each government can announce once and for all its policy {m,,gASo for the entire future, taking as given the announced policy {m:,g:} of the other. In game theoretical terms, I calculate a Nash open loop equilibrium. From such announcements, the private agents can perfectly foresee the equilibrium inflation rate and substituting out eq. (2) into eq. (l), one finds x,=x,+1
(8)
+cyt,
so that one sees that only transitory permitted. (This is a general feature of which the long-run Phillips curve is calculated by a standard Lagrangian domestic country)
x,=A,-_B-lA,_l; g,=O,
A-,=0,
output deviation (from zero) Taylor’s staggered wage models vertical). The equilibrium can multiplier and one finds (for
are in be the
(9) (10)
D. Cohen,
Monemy
4ndfisd
policy
in on open
economy
307
(11) The feature announced in the introduction is therefore apparent in eq. (10): because each country acts non-cooperatively, none of them will be induced to manipulate fiscal policy: each country will try to manipulate the exchange rate in order to attain its preferred output. In the same time, because only transitory output deviations are permitted, each government wants to promise a recession to-morrow in order to generate an expansion to-day which is not too inflationary. Since each government is alike and since it only uses beggar-my-neighbor policies, the equilibrium is necessarily one in which y, = y: = 0, so that the equilibrium values are readily calculated:
.oA! c
nr=
(12)
=Q
y,=y:
(13)
’
-(jr’-1)Jl’j; C
tz
1,
(14)
(see Oudiz and Sachs (1985) for a similar result). Both countries experience a positive burst of inflation when the program is announced and a constant deflation afterwards, reflecting each government’s intention to inflate initially and to deflate afterwards (in real terms) its economy. 3.2. Without intertemporal commitment Let us assume instead that the governments cannot announce their policies for the entire future and instead that they follow a ‘time-consistent* policy, i.e. one which is optimal to follow at each point in time when it is expected that future policies will be selected likewise. Assuming that the policy (m,,g,) is announced at the beginning of period t (before that wages are contracted), one can show that the policy is one which is best response to the ‘perceived Phillips curve n,=IS=+cy,,
(8’)
when fc is the expected inflation rate which is taken to be a constant by the government [see Cohen and Michel (1988)] so that the equilibrium (for the domestic economy) is now characterized as
D. Cohen, Monetary andfiscal p&y
308
n,=&,
in an open economy
vt10,
(9’)
g,=Q y,=y-
(10)
Lt.
(11)
$1
The difference with the reputational equilibrium is apparent: from eq. (9’) one sees that the government tries to inflate the economy each period so that each government (independently of the other’s move) is trapped into a selfdefeating monetary policy which yields
I&!,=a y,=4
I
vtzo.
The world equilibrium is obviously not different from the juxtaposition of these two self-defeating equilibria. 4. Cooperative equilibria Let us see now what cooperation can bring to the world economy. To the extent that each country is identical to the other, cooperative equilibria here are simply those for which each country agrees upon setting z,=O. This amounts, in the context of the model, to calculate the equilibria associated with a closed economy version of the model spelled out in section 2, when the beggar-thy-neighbor window is closed. 4.1. With intertemporal commitment of the government Here, the government wants to minimize (7) subject to
The equilibrium can simply be characterized as n,=l,-/rllt_l;
l-1=0,
ti 1 RAY, - J9+ #2&= eoc4-
(9) (10)
Each country now undertakes a policy in which fiscal policy only is aimed
D. Cohen, Monetary and jkal
policy in an open economy
30!3
at shifting output intertemporally. Solving the model explicatly shows that g,>O and gl=gll’ ~0 in which 1 is the solution smaller than one to (/I- ’- A)( 1-A) =(tjo/($rf?~ + $z))c&,. Fiscal policy is initially expansionary and, as early as in period one, it becomes contractionary. 4.2. Without intertemporal commitment The equilibrium is now described by eqs. (IO’), (11) and
(9”)
II,=&.
Each country now udertakes a self-defeating fiscal policy, and the equilibrium is characterized by 7C,=-
$1
c y;
g,=o.
Fear of systematic fiscal expansion raises inflation expectation up to the point where fiscal expansion is deterred. It is the cooperative analog to the equilibrium described in 3.2. in which monetary expansion was self-defeated. As one sees, cooperation without commitment does not necessarily help, a result initially obtained in Rogoff (1988). 5. Concluding remarks We have calculated four equilibria, with or without policy coordination and with or without policy commitment. Only one did not yield a self defeated policy. It was characterized by an active fiscal policy and a coordinated monetary policy. All non-cooperative equilibria were characterized by an active monetary policy which was always self-defeated. Cooperative monetary agreements unbacked by a government commitment to phase out its fiscal policy in the future were characterized by a self-defeating fiscal policy.
De Grauwc, P., 1986, Fiscal policies in the EMS: A strategic analysis, International Economics Research paper no. 53 (University of Leuven. Leuvcn). Oudk G. and J. Sachs, 1985, International policy coordination in dynamic macroeconomic models,in: Buitcr and Marston, eds., International economic policy coordination (Cambridge University Press, Cambridge). Rogoff, K.. 1985. Can international monetary cooperation be counterproductive?, Journal of International Economics 18, 199-217. Taylor, J., 1980, Aggregate dynamics and staggered contracts, Journal of Political Economy, Feb., l-23.
International Economics
MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY WITH OR WITHOUT POLICY COORDINATION
Daniel COHEN CEPREMAP, 75103, Paris, France and CEPR, London, UK
1. Introduction
The well publicized Plaza and Louvre agreements arguably set monetary policies in the G7 countries into a cooperative path aimed at stabilizing the six exchange rates of the seven richest industrialized countries. The crash of October 1987 shed a cold shower on these agreements. Critics have argued that coordinating monetary policies without also coordinating Escal policies makes no sense to the extent that fiscal policies are the ultimate ‘real’phenomenon that governments should take care of. By failing to trigger the fiscal corrections needed to bring the world balance of payments back into a sustainable path, agreements such as those taken in the Plaza or in the Louvre could only gain time and make harder the fall that would follow. The issue of whether fiscal policy coordination is a necessary correlate to monetary policy coordination is of obvious importance to the question of whether monetary agreements such as the EMS are intrinsically good or bad, and even more crucially it is a question which lies at the heart.of monetary integration in Europe [see de Grauwe (1986)]. If a European Central Bank were to be created, substituting a European currency to those circulating nowadays, should it impose fiscal cooperation on the member countries? If the answer to this question were to be a yes, it would cast a doubt on the feasibility of monetary integration. Fiscal policies are extremely costly to modify, much more than monetary policies are. They are the result of complex compromise between the executive and the legislative branches, their margins of maneuvers are notoriously narrow, and it is difftcult to imagine how two parliaments could consistently coordinate their decisions. Yet the example of national monetary integration shows that fiscal 001~2921/89/$3.50 @IJI 1989, Elscvier Science Publishers B.V. (North-Holland)
304
D. Cohen, Monetary andfiscal policy in an open economy
coordination of the member states (say of America) is not a prerequisite. Indeed no explicit mechanism imposes on Massachusetts to coordinate its fiscal policy with that of Indiana. Then, to return to the doubts expressed about the Louvre and Plaza agreements, what can be wrong in coordinating monetary policies alone? The view taken in this paper comes as follows. Monetary policy coordination alone is acceptable only if it is credible. Under this condition, it will by itself trigger the appropriate fiscal correction needed to make it sustainable. Explicit fiscal coordination may well be welfare enhancing, but it is not a prerequisite and it is an issue which should not be confused with that of setting each fiscal policy on a path which is consistent with a collectively accepted monetary policy. The failure of the U.S. fiscal policy to respond to the Plaza and Louvre agreements should not be viewed as an unavoidable feature which forecloses any monetary policy coordination. Instead it should be viewed as an endogeneous feature which reflects the fact that these agreement lacked the credibility which could have imposed on the U.S. congressmen the task of taking the appropriate fiscal corrections. In the case of a monetary integration of Europe, one by which monetary policy across the member states is necessarily identical (henceforth one for which the credibility issue cannot arise), each member state will necessarily take the fiscal action that is needed and one should not fear that observed fiscal inertia will be translated into ex-post fiscal irresponsibility. To illustrate these points, the model presented in this paper will show how a non-cooperativeequilibrium between two countries may induce each country to pursue a self-defeating monetary policy (by which each country tries to devalue its currency vis-a-vis the other) accompanied by no fiscal stimulusat all. On the other hand, a cooperative equilibrium will freeze monetary policy and, in that case, fiscal policies alone will be triggered in each country. In brief, the policy mix which is adopted by each country always takes an extreme form: when the equilibrium is a non-cooperative one, only monetary policy is manipulated; when the equilibrium is a cooperative one, only fiscal policy is used. The reason why (in the model which is presented) is straightforward: fiscal policy is costly (it has a distortionary bias) while monetary policy has a beggar-my-neighbor component (through the exchange rate). Any non-cooperative equilibrium will induce a government to manipulate monetary policy alone in order to export the cost of its adjustment abroad. It takes a credible monetary agrement to induce the government to resort to their distortionary domestic policy instruments. 2. The model
I will assume that the world is composed of two identical countries. All starred variables will refer to the foreign country, non-starred variables to the
D. Coheb Monetary andjiscal policy in an open economy
305
domestic country. Because of this symmetry, I will describe the domestic economy only. 2.1. Supply The model is a version of Taylor (1979) staggered wage contract model. Wages are negotiated every two periods, and I will assume that wage earners have an average real reservation wage which is a constant. Wages negotiated at time t are set according to (1)
(all small letters are logarithms; the wage units are normalized so as to let the reservation wage to be equal to 1). Firms’ prices are set according to a mark-up about average cost
(2) 2.2. Demand I will assume that demand is driven by two components: foreign demand and government spending
Y,= e,r, + &g,,
(3)
in which z, is the real exchange rate z,=e,+p,-p:.
(4)
e, is the nominal exchange rate. Demand here is extremely unsophisticated and no intertemporal substitution is taken into account. (In particular 8i may be viewed as a balancebudget multiplier in order to account for the government’s budget constraint). I will assume that only one good is sold home and abroad, but that trade is costly and that &,z, measures the response on demand of a price differential between the two countries. 2.3. Money demand Here again a simplified version is postulated: m, = P,- Ai,,
(5)
in which i, is the nominal interest rate and m, is the logarithm of money suPPlY*
D. Cohen, Monetary
306
andfical
policy
in an open
economy
2.4. Exchange rate I will assume that the uncovered interest rate arbitrage holds: i,=i:+E,(e,+,-e,).
(6)
2.5. Government 3 preferences The government form
tries to minimise an intertemporal
loss function of the
in which ~,=p~-p~_~ is the current inflation rate, and j( >O) is a government’s target for output. When j=O, each government can attain it first best by setting m =m: =0 and gt=g: =O. When JJ and j* are strictly positive some action will be undertaken and the outcome will depend crucially upon the set of strategies each government has access to. I will distinguish four types of equilibria: Non-cooperative and cooperative ones, on the one hand, reputational and non-reputational equilibria on the other hand. 3. Non-cooperative equilibria 3.1. With intertemporal commitment of the government I will assume, here, that each government can announce once and for all its policy {m,,gASo for the entire future, taking as given the announced policy {m:,g:} of the other. In game theoretical terms, I calculate a Nash open loop equilibrium. From such announcements, the private agents can perfectly foresee the equilibrium inflation rate and substituting out eq. (2) into eq. (l), one finds x,=x,+1
(8)
+cyt,
so that one sees that only transitory permitted. (This is a general feature of which the long-run Phillips curve is calculated by a standard Lagrangian domestic country)
x,=A,-_B-lA,_l; g,=O,
A-,=0,
output deviation (from zero) Taylor’s staggered wage models vertical). The equilibrium can multiplier and one finds (for
are in be the
(9) (10)
D. Cohen,
Monemy
4ndfisd
policy
in on open
economy
307
(11) The feature announced in the introduction is therefore apparent in eq. (10): because each country acts non-cooperatively, none of them will be induced to manipulate fiscal policy: each country will try to manipulate the exchange rate in order to attain its preferred output. In the same time, because only transitory output deviations are permitted, each government wants to promise a recession to-morrow in order to generate an expansion to-day which is not too inflationary. Since each government is alike and since it only uses beggar-my-neighbor policies, the equilibrium is necessarily one in which y, = y: = 0, so that the equilibrium values are readily calculated:
.oA! c
nr=
(12)
=Q
y,=y:
(13)
’
-(jr’-1)Jl’j; C
tz
1,
(14)
(see Oudiz and Sachs (1985) for a similar result). Both countries experience a positive burst of inflation when the program is announced and a constant deflation afterwards, reflecting each government’s intention to inflate initially and to deflate afterwards (in real terms) its economy. 3.2. Without intertemporal commitment Let us assume instead that the governments cannot announce their policies for the entire future and instead that they follow a ‘time-consistent* policy, i.e. one which is optimal to follow at each point in time when it is expected that future policies will be selected likewise. Assuming that the policy (m,,g,) is announced at the beginning of period t (before that wages are contracted), one can show that the policy is one which is best response to the ‘perceived Phillips curve n,=IS=+cy,,
(8’)
when fc is the expected inflation rate which is taken to be a constant by the government [see Cohen and Michel (1988)] so that the equilibrium (for the domestic economy) is now characterized as
D. Cohen, Monetary andfiscal p&y
308
n,=&,
in an open economy
vt10,
(9’)
g,=Q y,=y-
(10)
Lt.
(11)
$1
The difference with the reputational equilibrium is apparent: from eq. (9’) one sees that the government tries to inflate the economy each period so that each government (independently of the other’s move) is trapped into a selfdefeating monetary policy which yields
I&!,=a y,=4
I
vtzo.
The world equilibrium is obviously not different from the juxtaposition of these two self-defeating equilibria. 4. Cooperative equilibria Let us see now what cooperation can bring to the world economy. To the extent that each country is identical to the other, cooperative equilibria here are simply those for which each country agrees upon setting z,=O. This amounts, in the context of the model, to calculate the equilibria associated with a closed economy version of the model spelled out in section 2, when the beggar-thy-neighbor window is closed. 4.1. With intertemporal commitment of the government Here, the government wants to minimize (7) subject to
The equilibrium can simply be characterized as n,=l,-/rllt_l;
l-1=0,
ti 1 RAY, - J9+ #2&= eoc4-
(9) (10)
Each country now undertakes a policy in which fiscal policy only is aimed
D. Cohen, Monetary and jkal
policy in an open economy
30!3
at shifting output intertemporally. Solving the model explicatly shows that g,>O and gl=gll’ ~0 in which 1 is the solution smaller than one to (/I- ’- A)( 1-A) =(tjo/($rf?~ + $z))c&,. Fiscal policy is initially expansionary and, as early as in period one, it becomes contractionary. 4.2. Without intertemporal commitment The equilibrium is now described by eqs. (IO’), (11) and
(9”)
II,=&.
Each country now udertakes a self-defeating fiscal policy, and the equilibrium is characterized by 7C,=-
$1
c y;
g,=o.
Fear of systematic fiscal expansion raises inflation expectation up to the point where fiscal expansion is deterred. It is the cooperative analog to the equilibrium described in 3.2. in which monetary expansion was self-defeated. As one sees, cooperation without commitment does not necessarily help, a result initially obtained in Rogoff (1988). 5. Concluding remarks We have calculated four equilibria, with or without policy coordination and with or without policy commitment. Only one did not yield a self defeated policy. It was characterized by an active fiscal policy and a coordinated monetary policy. All non-cooperative equilibria were characterized by an active monetary policy which was always self-defeated. Cooperative monetary agreements unbacked by a government commitment to phase out its fiscal policy in the future were characterized by a self-defeating fiscal policy.
De Grauwc, P., 1986, Fiscal policies in the EMS: A strategic analysis, International Economics Research paper no. 53 (University of Leuven. Leuvcn). Oudk G. and J. Sachs, 1985, International policy coordination in dynamic macroeconomic models,in: Buitcr and Marston, eds., International economic policy coordination (Cambridge University Press, Cambridge). Rogoff, K.. 1985. Can international monetary cooperation be counterproductive?, Journal of International Economics 18, 199-217. Taylor, J., 1980, Aggregate dynamics and staggered contracts, Journal of Political Economy, Feb., l-23.