Transcript Policy game in the global economy

Economic Modelling
Lecture 19
Policy Game in the Global Economy
1
Growing Together or Growing Apart?
East and West?
North and South?
Source: Phillip’s Atlas of the World
2
Two Economy Inter-dependent Global Economy Model
Economy 1
Y1  C1  I1  G1  X1  M1
M1  m1Y1
X1  k1Y2
Economy 2
Y2  C2  I 2  G2  X 2  M 2
X 2  k2Y1
M 2  m2Y2
 C1  I1  G1 1  m2    k1 C2  I 2  G2  
Y1  








 1  m1 1  m2  k1k2   1  m1 1  m2  k1k2 
What is Y2 ?
3
Cooperation or non-Cooperation?
...............................
Advanced Countries

Developing Countries  NC
 C
NC C 
4,4 6,3
3,6 5,5
Nash Solution is non-cooperation (NC,NC) =(4,4)
...............................
Advanced Countries

Developing Countries  NC
 C
NC C 
4, 4 6,3
3, 6 5,5
Cooperative Solution (C,C) =(5,5)
Cooperative solution Pareto dominated Non-cooperative solution.
Pareto efficiency: at least one party gains without hurting the other.
4
Extensive Form of International Cooperation Game
NC
NC
(4,4)
Advanced
economies
C
(6,3)
(3,6)
Developing
Economies
NC
C
Advanced
economies
C
(5,5)
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Dynamics of International Policy Cooperation Game: Solution by Backward Induction
NC
NC
(4,4)
Advanced
economies
C
(6,3)
(3,6)
Developing
Economies
NC
C
Advanced
economies
C
(5,5)
6
Credibility Problem, Cheating and Discount Factor of the Game
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
PV (C , C )  5  5  5 2  5 3  ...  5 n 
PV (C , C )  5  5  5 2  5 3  ...  5 n 
Lim n 
5
1 
5
1 
PV (cheat )  6  4  4 2  4 3  ...  4 n
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Solution for the Discount Factor of the Game
PV (C , C )  5  5  5 2  5 3  ...  5 n 
Lim n 
5
1 
PV (cheat )  6  4  4 2  4 3  ...  4 n
PV (cheat )  6  4 2  4 3  ...  4 n1
1   PV (cheat )  6  6  4
PV (cheat )  6  4
lim n

1   
5

 6 4
1   
1
5  61     4
 n1  0
6  5  2
1
 
2
8
Internal and External Stability in an Open Economy
S
K Inflow
K Inflow
i=i*
K outflow
K outflow
Unemployment
Deflation
X-M=0
Inflation
Boom
0
Yn
output
9
Macroeconomic Equilibrium in a Small Open Economy
with Perfect Capital Mobility
S
IS
LM
i>i*
BOP+ K inflow
BOP+
Boom
K-inflow
Deflation
BOP: X-M =-KA
i=i*
BOP- Outflow
Boom/inflation
Over full employment
BOPK-outflow
Deflation
i<i*
Under full employment.
Yf
10
A Small Open Economy with Perfect Capital Mobility:
Convergence towards A Macroeconomic Equilibrium
S
IS
LM
EXSG
i>i*
BOP+
BOP+
EXDM
EXSG
EXDG
EXSM
EXDM
BOP: X-M =-KA
i=i*
BOPEXSG
EXDM
BOP-
i<i*
EXDG
ESM
EXDG
EXDM
Yf
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
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Interdependent Global Economy: IS-LM-BP Model
IS1
LM1’
2
1
i
LM2’
LM2
LM1
IS1’
4
6
5
i
3
1
IS2’
IS2
y1
Country 1 adopts expansionary fiscal policy output and
interest rates, imports and reserves of foreign currency rise in
Country 2 can export more to country 1 but looses some foreign
country 1.
assets, money supply decreases, and demand decreases and may
have contractionary impact if its increase in exports are less than
it lose of reserves.
y2
12
Policy Spill-over Effects in Interdependent
Economies
Answer: Use a two country Mundell-Fleming Model
Expansionary fiscal policy in country 1
Impact in country 2
i2=i2*
i1=i1*
BOP
LM2’
LM2
LM1 LM2
IS2 IS2’
IS1’
O
y0
IS1
y1 y2
In fixed exchange rate with perfect capital
o
Y
mobility: g  0
y0 y2 y1
;
Y *
0
g
R
; g  0
R *
; g  0
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International Economic Policy Coordination
• 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
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Interdependent Global Economy: An Example
Blanchard (19.5)
C  10  0.8Y  T  ; I  10 ; G  10 ; T  10 ;
M  0.3Y ; X  0.3Y *
Y  C  I  G  X  M  10  0.8Y  T   I  G  0.3Y *  0.3Y
Y  0.5Y  10  0.810  I  G  0.3Y * =>
Y  44  0.6Y *
Multipliers:
1
Open Economy: 1  0.8  0.3  2
Closed economy:
1
5
1  0.8
1
Interdependent Economy: 1  0.8  0.30.6  0.3  3.125
44
*
*
Y

 110
Y  44  0.6Y ; => Y  0.6Y  44 =>
0 .4
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Policy Spill-over Effect -1
Suppose target income at home is Y =125.
Foreign income then Y  44  0.6125  119
The government expenditure to achieve target
income given this foreign income
*
Y  0.5Y  10  0.810  I  G  0.3Y =>
*
Y  24  2G  0.6Y * ; Y  24  2G  0.6119 =>
G= 14.8
Net export at home NX  0.3119  0.3125  1.8 ;
Government budget deficit at home:
T  G  10  14.8  4.8
*
*
Budget deficit abroad T  G  0 ; and Foreign
country’s net export:
NX  0.3119  0.3125  1.8
=>foreign country benefits by doing nothing.
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Policy Spill-over Effect
If both countries like to achieve 125 level
of target output;
the common increase in G necessary to
achieve this target output can be found as:
Y  Y *  125 ;
Y  24  2G  0.6125 =>
2G  125  75  24  26 =>
G  13 NX  NX  0 ;
*
T  G  T *  G *  3
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Autarky: Saving, Capital Accumulation and Growth
(Gartner (2003:262) has similar example)
Country A
Country B
YA  K A0.5 L0A.5
 A  0.1
YB  K B0.5 L0B.5
s A  0.2
sB  0
What is the capital stock in the
steady state in A in Autarky?
How much do workers get?
How much do owners of
capital get?
sK A0.5 L0A.5   A K A
0.2 K A0.5 10  0.1K A

K A  400
 B  0.1
What is the capital stock in the
steady state in B in Autarky?
How much do workers get?
How much do owners of
capital get?
0.0 K B0.5 10  0.1K B
 K B  0 YB  0
 Becomes a beggar country.
YA  200
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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?
Country A
Country B
K A  KB  K
K A  KB  K
Country A saves for both
countries. It receives rental
income from country B.
Country B does not save
but can borrow capital from
country A.


0.2 10 K 0.5  0.5  10 K 0.5  0.1K  K 
K  15  225
YB  K 0.5 L0B.5  225 0.5  10  150
2
YA  K 0.5 L0A.5  225 0.5  10  150
GNP in country B =
GDP+Investment Receipts
GNPA = 150+75 = 225
Capitalists gain and
workers lose in country A.
Country B need to pay
capital income to Country
A.
GNP in country B = GDPInvestment Payments
GNPB = 150-75 = 75
Country B gains from the
capital transfers.
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Growth rate of money supply in foreign country
International Monetary Policy Co-ordination GAME :Hammada Diagram
(Romp p.175)
R: domestic reaction
B
IC*
IC
C
R*: foreign reaction
B*
gmN*
N
450
B: Domestic bliss
B*: Foreign bliss
C: Pareto optimal
N: Nash Equilibrium
gmN
Growth rate of money supply in home country
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Optimal Tariff Game: Johnson (1954)
Nash equilibrium is not Pareto Optima
as the indifference curves cross each
but are not tangential.
t*
N
A*
I1*
R*
I2*
I3
A
I2
t
R
I3*
I1
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Optimal Tariff Game: Johnson (1954)
Nash equilibrium is not Pareto Optimal
as the indifference curves cross each other
but are not tangential.
t*
EE line shows all Pareto Efficient poin
N
A*
E
I1*
R*
I2*
I3
A
I2
t
R
I3*
I1
E
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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,
2001.
•
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 NonCooperative Behaviour”, International Economic Review, 26:3:1985, pp. 547-567.
•
Benigno, Pierpaolo (2002) A Simple Approach to International Monetary Policy Coordination; Journal of
International Economics, June 2002, v. 57, iss. 1, pp. 177-96
•
Johnson H. G.(1953-54) Optimal tariffs and Retaliation, Review of Economic Studies, 21(2),
pp.142-43.
•
Harrison, G.W., T.F.Rutherford and D.G. Tarr (1997) “Quantifying the Uruaguy Round”, Economic Journal vol. 107
no. 444, September, pp.1405-1430,
•
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.1007-1051.
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 coordination of economic policies, Institute of International Economics, Washington.
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



Should Policy be Active or Passive?
Classical Economists on Economic Policy
Economy left itself will do better than with
an active intervention.
Perfectly flexible prices of goods, labour
and capital guarantee full employment
equilibrium consistent with maximisation of
welfare.
Supply creates its own demand in a free
market economy (general equilibrium model
as we discussed in micro foundation part
describe the frictionless economy).
Classical economists believed that active
policy may do more harm than good.
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Lags in Economic Policy
 Recognition lag:
turning points of business cycle difficult to
recognise
 Decision lag:
parliamentary process,
dispute among political parties
 Implementation lag:
It takes time for policy to reach to grassroot
level
 Impact lag:
institutional and technological inertial and
persistent habits
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Classical, Keynesian and Monetarist Approaches to Economic Policy
Classical economists suggest
“do-nothing” or “do minimum” policy to
be better than an active policy.
- Well-intentioned policy makers do more
harm than good.
- The self interest of the policy makers
may not be in the best interest of the
country.
- Money is neutral.
Monetarist argue for a money supply
rule such as the interest rate rule
Keynesian favour active policy
New-classical like classical argue for
minimum role of the government
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