Working Paper: CEPR ID: DP102
Authors: Paul Levine; David Currie
Abstract: The paper investigates the sustainability of cooperative rules for the conduct of macroeconomic policy in a two-country world. The problem is set out as a supergame in which the threat strategy is to switch to a Nash non-cooperative equilibrium. A number of possible non-cooperative equilibria are reviewed, and two are analysed in detail as possible threat strategies. The first is an open-loop Nash equilibrium where the government is able to precommit itself to the policies it announces. This policy is time inconsistent so we discuss an alternative threat, a time-consistent closed-loop Nash equilibrium. Similarly time inconsistent and time consistent forms of cooperative equilibria are examined. We apply these solution concepts to a small two-country model with in which we impose parameter values. We discover that the presence of stochastic disturbances in the model enables the fully optimal (and time-inconsistent) cooperative policy to be sustainable. The optimal policy is sustainable not only when both governments can renege on the policies they announce to the private sector, and a reneging of one, but also when one government reneges on the other.
Keywords: cooperative rules; sustainability; macroeconomic policy; Nash equilibria; time consistency; repeated games; reputation effects
JEL Codes: 023; 400; 423
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Optimal Cooperative Policy (C71) | Sustainable Cooperative Policy (P13) |
| Government Engaging in Announced Policies (H59) | Sustainability of Cooperative Policies (P13) |
| Incentive for One Government to Renege (H74) | Breakdown of Cooperation (D74) |
| One Government Deviating from Cooperative Policies (H19) | Noncooperative Equilibrium (C72) |
| Noncooperative Equilibrium (C72) | Detrimental Outcome for Both Parties (D52) |
| Time Inconsistency in Policy Announcements (E61) | Challenges in Sustaining Cooperation (D74) |
| Reputation Effects (D83) | Sustaining Cooperative Behavior (C71) |