The failure to cooperate and coordinate macroeconomic policies will leave countries worse off than an outcome involving cooperation Most countries around the world interest in international economic cooperation have increased substantially in recent years. This heightened desire to coordinate economic policies with the major economic power is in part a response to the special problems (e. g. the sharp fluctuation in exchange rates) and the changes in the world economy.
The world economy has become more interdependent: international trade has increases relative to production for domestic markets and international capital markets have become larger and more active. The failure to cooperate and coordinate macroeconomic policies will leave countries worse off than an outcome involving cooperation. The basic theoretical model of interdependence is the two-country model developed by Robert Mundell (1963) and J. Marcus Fleming (1962).
Then McKibbin and Sachs (1991) develop a multi-country model, which allows for flexible wages and prices and rational expectations. The basic two-country Mundell-Fleming model was the first to study macroeconomic interaction in a formal theoretical setting under the realistic assumption of high capital mobility between the 'home' and 'foreign' countries. This model examines the transmission of monetary and fiscal policies under different assumption about exchange rate flexibility, wage setting, and capital mobility.
(See Table 1) First, consider the expansionary monetary policy. Under the floating exchange rates conditions, the domestic monetary expansion always causes a depreciation of the home currency and a rise in home output, and it is usually regarded as a classic example of a 'beggar-thy-neighbor' policy because it result in an expansion of domestic output at the expense of foreign output.
Assuming fixed exchange rates, in the case in which the foreign country is responsible for fixing the exchange rate, the monetary expansion in the home country will lead to a monetary expansion in the foreign country that is necessary to hold the exchange rate fixed. The result is a global monetary expansion. Second, consider the fiscal policy transmission. For the floating exchange rates, fiscal policy is positively transmitted: higher fiscal spending at home raises output abroad.
A fiscal expansion in the home country, increasing domestic demand, brings about an appreciation of the exchange rate that reduces foreign demand by enough that the output effects are zero. Note that the domestic fiscal expansion has a negative effect on the price level because the appreciation of the home currency lowers the price of foreign goods in the home market, which means on impact, and per unit of output expansion achieved, fiscal policy is less inflationary than monetary policy.
If the home country fixes the exchange rate, a home fiscal expansion tends to appreciate the home currency. To offset the incipient appreciation requires a monetary expansion in the home country. The output effects are clear because the monetary policy expansion will reinforce the expansionary effects of the fiscal expansion. Under a given exchange rate regime, the move to indexation reduces the real effects on both the home and foreign countries' output of a given fiscal policy change. (McKibben & Sachs ,1991) Table 1. A Monetary-Fiscal Game Policy coordination has been defined numerous ways.
Here, definition of the Group of 30 countries in 1988 will be adopted: countries modify their economic policies in what is intended to be a mutually beneficial manner, taking account of international economic linkages. And Cooper has expressed that the central issue of international economic cooperation is to keep the manifold benefits of extensive international intercourse free of crippling restrictions, while at the same time preserving a maximum degree of freedom for each nation to pursue its legitimate economic objectives. (Hallwood and MacDonald, 2000)
It is useful to consider two extreme positions to understand the international economic cooperation and policy coordination. At one extreme is the idea that each country should manage its own domestic monetary and fiscal policies with a concern for its own well-being only and without trying to take into account the effect of its policies on the other countries of the world. A government may understand that its economy is affected by the policies adopted elsewhere and that its own policies affect other countries but still choose to make its policy decisions unilaterally.
At the other extreme is the view that each country should formulate its economic policies in explicit coordination with every other country, so that the policies are chosen to maximize world economic welfare as a whole, or at least to achieve an aim of policies from which no country can be made better off without making some other country worse off. This statement of the alternatives might suggest that international coordination is unambiguously better than the uncoordinationated pursuit of national self-interest.
The ability of international macroeconomic coordination to permit countries to pursue more expansionary policies than would otherwise be possible is both a potential benefit and a potential danger. For instance, when a single country tries to expand by itself, it may soon find that rising imports create a balance of payments problem. A coordinated expansion by a group of trading partner can eliminate this balance of payment constraint and permit all of the countries to expand more than any of them could have done alone.
When all economies are operating well below capacity, such coordination expansion can provide gains for all. In the most independent arrangement, each country chooses its optimal policy taking the policy action of the other country as given. Equilibrium in each country is reached at the point where the benefits of expansion are balanced by the costs of appreciation, given the other country's decision. This is noncooperative equilibrium. Cooperation may result in less active use of the policy than when the countries are independently pursuing their own interests.
(Feldstein, 1988)For example, suppose the targets of policy are output and inflation, and monetary policy is the only instrument. In the nonocooperative equilibrium, each country is balancing the costs of added inflation against the benefit of higher output. But an expansionary policy in each country reduces output in the other. If monetary policy in each economy becomes less expansionary, the same income levels can be attained at a lower rate of inflation.
Any single country's policies have some 'spillover' effects on other countries, and the perceived constraints on policy action (the state of the balance of payments or the direction of change of the exchange rate) depend for any one country on the actions of other countries, the individualistic pursuit of economic policy is quite unlikely to be optimal. In the absence of direct cooperation, it is well known that the outcomes of such games are socially inefficient; there are alternative policies that would make all parties better off.
The benefits of coordination can be illustrated at a basic level using the famous prisoner's dilemma game. (See Table 2)This game is described as static in nature because the game relates to the domestic country and foreign country each trying to set the optimal level of their monetary policy in response to an inflationary shock. (Hallwood and MacDonald, 2000) And the issues are illustrated in the following using a diagram developed by Hamada (1979).