1 Economic Modelling Lecture 19 Policy Game in the Global Economy

2 Source: Phillips Atlas of the World Growing Together or Growing Apart? East and West? North and South?

3 Two Economy Inter-dependent Global Economy Model Economy 1 Economy 2 What is Y2 ?

4 Cooperation or non-Cooperation? Nash Solution is non-cooperation (NC,NC) =(4,4) Cooperative Solution (C,C) =(5,5) Cooperative solution Pareto dominated Non-cooperative solution. Pareto efficiency: at least one party gains without hurting the other.

5 Developing Economies Advanced economies Extensive Form of International Cooperation Game NC C C C (4,4) (6,3) (3,6) (5,5) Advanced economies

6 Developing Economies Advanced economies Dynamics of International Policy Cooperation Game: Solution by Backward Induction NC C C C (4,4) (6,3) (3,6) (5,5) Advanced economies

7 Both gain by playing (C,C) But this solution is not credible. There is incentive to deviate. Trigger Strategy Game returns to Nash path in absence of credibility. If the game is played infinite number of times the optimal discount value ff the game is calculated as Credibility Problem, Cheating and Discount Factor of the Game

8 Solution for the Discount Factor of the Game

9 Yn Unemployment Deflation Inflation Boom i=i* S K Inflow X-M=0 K outflow Internal and External Stability in an Open Economy output 0

10 Yf i=i* IS LM S BOP+ K-inflow Deflation i>i* i<i* BOP+ K inflow Boom BOP: X-M =-KA BOP- K-outflow Deflation Under full employment. BOP- Outflow Boom/inflation Over full employment Macroeconomic Equilibrium in a Small Open Economy with Perfect Capital Mobility

11 Yf i=i* IS LM S BOP+ EXDG EXSM i>i* i<i* BOP+ EXSG EXDM BOP: X-M =-KA BOP- EXDG ESM BOP- EXSG EXDM A Small Open Economy with Perfect Capital Mobility: Convergence towards A Macroeconomic Equilibrium Notes: YF full employment output, BOP = Balance of Payment, K= capital, ESG =Excess supply of goods, EDG =Excess demand for goods, ESM =excess supply of money, EDM=excess demand for money EXSG EXDM EXDG EXDM

Interdependent Global Economy: IS-LM-BP Model 1 i i y2 y1 IS1 LM1 LM2 IS2 LM2 IS2

13 Policy Spill-over Effects in Interdependent Economies

14 International Economic Policy Co- ordination Gold-Standard: Automatic Adjustment Mechanism Bretton Woods-Dollar standards Break down of the Bretton Woods: Exchange rate crises Plaza and Lauvre Accords and G7 Meetings EU Growth and Stability Pact Basel agreement of central banks, EMU, AMU, ECOWAS IMF/ WB: Seal of approval - Paris Club GATT-WTO-NAFTA-APEC-ASEAN-GCC What are right models for Co-operation or negotiations?

15 Interdependent Global Economy: An Example Blanchard (19.5)

16 Policy Spill-over Effect -1

17 Policy Spill-over Effect

18 Autarky: Saving, Capital Accumulation and Growth (Gartner (2003:262) has similar example)

19 Impacts of Globalisation in Output and Income What is the capital stock in the steady state in A and B if there is a free mobility of capital?

20 R*: foreign reaction R: domestic reaction 45 0 B B* C Growth rate of money supply in foreign country Growth rate of money supply in home country N gmN gmN* International Monetary Policy Co-ordination GAME :Hammada Diagram (Romp p.175) IC IC* B: Domestic bliss B*: Foreign bliss C: Pareto optimal N: Nash Equilibrium

21 t* t R* R Optimal Tariff Game: Johnson (1954) A A* I1 I2 I3 I1* I2* I3* N Nash equilibrium is not Pareto Optimal as the indifference curves cross each other but are not tangential.

22 t* t R* R Optimal Tariff Game: Johnson (1954) A A* I1 I2 I3 I1* I2* I3* N Nash equilibrium is not Pareto Optimal as the indifference curves cross each other but are not tangential. E E EE line shows all Pareto Efficient points

23 References Blanchard (2003) Macroeconomics, Prentice Hall. Bhattarai (2001) Welfare Gains to UK from a Global Free Trade, the European Research Studies, Vol. IV, Issue 3-4, Binmore Ken (1999) Applying Game Theory of Automated Negotiation, Netnomics,1999, v.1, iss.1 pp.1-9. Canzoneri M. B. and J A Gray (1985) Monetary Policy Games and the Consequences of Non- Cooperative Behaviour, International Economic Review, 26:3:1985, pp Benigno, Pierpaolo (2002) A Simple Approach to International Monetary Policy Coordination; Journal of International Economics, June 2002, v. 57, iss. 1, pp Johnson H. G.( ) Optimal tariffs and Retaliation, Review of Economic Studies, 21(2), pp Harrison, G.W., T.F.Rutherford and D.G. Tarr (1997) Quantifying the Uruaguy Round, Economic Journal vol. 107 no. 444, September, pp , Binmore Ken (1999) Applying Game Theory of Automated Negotiation, Netnomics,1999, v.1, iss.1 pp.1-9. Hamada K (1976) Strategic Analysis of Monetary Interdependence, Journal of Political Economy, 84 August. Ranis Gustav and L. Raut (1999) ed. Trade Growth and Development, North Holland. Shoven, J. B. and J.Whalley (1984) Applied General-Equilibrium Models of Taxation and International Trade: An Introduction and Survey, Journal of Economic Literature, vol. XXII, Sept,1984, pp Whalley John (1985) Trade Liberalisation Among Major Trading Areas, The MIT Press. Williamson J. and M. Miller (1987) Targets and indicators: a blue print for international co- ordination of economic policies, Institute of International Economics, Washington.

24 Should Policy be Active or Passive? Classical Economists on Economic Policy

25 Lags in Economic Policy

26 Classical, Keynesian and Monetarist Approaches to Economic Policy