Monetary policy strategies in the world economy carlberg_9

2. Fiscal Policies in Europe and America: Absence of a Deficit Target 251 2.2 Fiscal Cooperation between Europe and America The policy makers are the European government and the American government. The targets of fiscal cooperation are zero unemployment in Europe and America. The instruments of fiscal cooperation are European government purchases and American government purchases. There are two targets and two instruments. We assume that the European government and the American government agree on a common loss function. The amount of loss depends on unemployment in Europe and America. The policy makers set European government purchases and American government purchases so as to minimize the common loss. The cooperative equilibrium is determined by the first-order conditions for a minimum loss. It yields the optimum levels of European government purchases and American government purchases. As a result, the cooperative equilibrium is identical to the corresponding Nash equilibrium. That is to say, fiscal cooperation is equivalent to fiscal interaction. For some numerical examples see Section 2.1. 252 Conclusion 3. Fiscal Policies in Europe and America: Presence of a Deficit Target 3.1. Fiscal Interaction between Europe and America 1) The model. An increase in European government purchases lowers European unemployment. On the other hand, it raises European inflation. And what is more, it raises the European structural deficit. Correspondingly, an increase in American government purchases lowers American unemployment. On the other hand, it raises American inflation. And what is more, it raises the American structural deficit. An essential point is that fiscal policy in Europe has spillover effects on America and vice versa. An increase in European government purchases lowers American unemployment and raises American inflation. Similarly, an increase in American government purchases lowers European unemployment and raises European inflation. In the numerical example, a unit increase in European government purchases lowers European unemployment by 1 percentage point. On the other hand, it raises European inflation by 1 percentage point. And what is more, it raises the European structural deficit by 1 percentage point. A unit increase in European government purchases lowers American unemployment by 0.5 percentage points and raises American inflation by 0.5 percentage points. However, it has no effect on the American structural deficit. For instance, let European unemployment be 2 percent, let European inflation be 2 percent, and let the European structural deficit be 2 percent as well. Further, let American unemployment be 2 percent, let American inflation be 2 percent, and let the American structural deficit be 2 percent as well. Now consider a unit increase in European government purchases. Then European unemployment goes from 2 to 1 percent. European inflation goes from 2 to 3 percent. And the European structural deficit goes from 2 to 3 percent as well. American unemployment goes from 2 to 1.5 percent. American inflation goes from 2 to 2.5 percent. And the American structural deficit stays at 2 percent. 3. Fiscal Policies in Europe and America: Presence of a Deficit Target 253 The targets of the European government are zero unemployment and a zero structural deficit in Europe. The instrument of the European government is European government purchases. There are two targets but only one instrument, so what is needed is a loss function. We assume that the European government has a quadratic loss function. The amount of loss depends on unemployment and the structural deficit in Europe. The European government sets European government purchases so as to minimize its loss. From this follows the reaction function of the European government. Suppose the American government raises American government purchases. Then, as a response, the European government lowers European government purchases. The targets of the American government are zero unemployment and a zero structural deficit in America. The instrument of the American government is American government purchases. There are two targets but only one instrument, so what is needed is a loss function. We assume that the American government has a quadratic loss function. The amount of loss depends on unemployment and the structural deficit in America. The American government sets American government purchases so as to minimize its loss. From this follows the reaction function of the American government. Suppose the European government raises European government purchases. Then, as a response, the American government lowers American government purchases. The Nash equilibrium is determined by the reaction functions of the European government and the American government. It yields the equilibrium levels of European government purchases and American government purchases. As a rule, unemployment in Europe and America is not zero. And the structural deficits in Europe and America are not zero either. 2) A demand shock in Europe. We assume equal weights in each of the loss functions. Let initial unemployment in Europe be 3 percent, and let initial unemployment in America be zero percent. Let initial inflation in Europe be – 3 percent, and let initial inflation in America be zero percent. Let the initial structural deficit in Europe be zero percent, and let the initial structural deficit in America be the same. Step one refers to the policy response. According to the Nash equilibrium there is an increase in European government purchases of 1.6 units and a 254 Conclusion reduction in American government purchases of 0.4 units. Step two refers to the outside lag. Unemployment in Europe goes from 3 to 1.6 percent. Unemployment in America goes from zero to – 0.4 percent. Inflation in Europe goes from – 3 to – 1.6 percent. Inflation in America goes from zero to 0.4 percent. The structural deficit in Europe goes from zero to 1.6 percent. And the structural deficit in America goes from zero to – 0.4 percent. For a synopsis see Table 9.7. Table 9.7 Fiscal Interaction between Europe and America A Demand Shock in Europe Europe America Unemployment 3 Inflation − 3 Structural Deficit 0 Change in Govt Purchases 1.6 Unemployment 1.6 Inflation − 1.6 Structural Deficit 1.6 Unemployment 0 Inflation 0 Structural Deficit 0 Change in Govt Purchases − 0.4 Unemployment − 0.4 Inflation 0.4 Structural Deficit − 0.4 First consider the effects on Europe. As a result, given a demand shock in Europe, fiscal interaction lowers unemployment and deflation in Europe. On the other hand, it raises the structural deficit there. Second consider the effects on America. As a result, fiscal interaction produces overemployment and inflation in America. And what is more, it produces a structural surplus there. 3. Fiscal Policies in Europe and America: Presence of a Deficit Target 255 3.2. Fiscal Cooperation between Europe and America 1) The model. The policy makers are the European government and the American government. The targets of fiscal cooperation are zero unemployment and a zero structural deficit in each of the regions. The instruments of fiscal cooperation are European government purchases and American government purchases. There are four targets but only two instruments, so what is needed is a loss function. We assume that the European government and the American government agree on a common loss function. The amount of loss depends on unemployment and the structural deficit in each of the regions. The policy makers set European government purchases and American government purchases so as to minimize the common loss. The cooperative equilibrium is determined by the first-order conditions for a minimum loss. It yields the optimum levels of European government purchases and American government purchases. 2) A demand shock in Europe. We assume equal weights in the loss function. Let initial unemployment in Europe be 3 percent, and let initial unemployment in America be zero percent. Let initial inflation in Europe be – 3 percent, and let initial inflation in America be zero percent. Let the initial structural deficit in Europe be zero percent, and let the initial structural deficit in America be the same. Step one refers to the policy response. What is needed, according to the model, is an increase in European government purchases of 1.29 units and an increase in American government purchases of 0.09 units. Step two refers to the outside lag. Unemployment in Europe goes from 3 to 1.66 percent. Unemployment in America goes from zero to – 0.74 percent. Inflation in Europe goes from – 3 to – 1.66 percent. Inflation in America goes from zero to 0.74 percent. The structural deficit in Europe goes from zero to 1.29 percent. And the structural deficit in America goes from zero to 0.09 percent. For an overview see Table 9.8. ... - tailieumienphi.vn