Fiscal and monetary policies in a monetary union: Conflict or cooperation?

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 of a monetary union for analyzing 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 equilibrium solutions for four game strategies: one cooperative (Pareto optimal) and three non-cooperative game types: the Nash game for the open-loop information pattern, the Nash game for the feedback information pattern, and the Stackelberg game for the feedback information pattern. Applying the OPTGAME algorithm to the MUMOD1 model we show how the policy makers react upon demand and supply shocks according to different solution concepts. Some comments are given on possible applications to the recent sovereign debt crisis in Europe. We show that the non-cooperative equilibrium solutions (open-loop Nash and Stackelberg) are close to each other, while the cooperative solution differs from them by using its instruments in a more active way, in particular during the financial and economic crisis. The reason for this is the confidence each policy maker obtains from the cooperation agreement, which can be interpreted as a fiscal pact concluded by the governments of the monetary union and the common central bank. We stress the importance of the assumption that the agreement is unambiguously enforced and comment upon the institutional requirements for this assumption to hold under the actual conditions of the European Economic and Monetary Union and the Euro Area.