Working Paper: CEPR ID: DP115
Authors: Frederick van der Ploeg
Abstract: It is shown that, when there is a genuine long-run trade-off between inflation and output, coordination under pre-commitment yields substantial improvements in economic welfare. The analysis is conducted within the context of a two-country model with capital accumulation, immobile labour, perfect capital mobility and floating exchange rates. If the home government increases its monetary growth rate, it increases home inflation, reduces the world real interest rate and therefore boosts both home and foreign capital accumulation. The foreign country thus enjoys a gain in output without suffering from higher inflation. Competitive policies lead to monetary policies which are too tight and levels of activity which are too low, since each country attempts to be a "free rider". Coordination leads to a lower world real interest rate and higher welfare. Pre-commitment is necessary, for the success of coordinated policies, however. Otherwise each government has an incentive to renege and levy a "surprise" inflation tax. In the absence of binding contracts or reputation effects, both cooperation and competitive policy formulation lead to excessive monetary growth rates and higher levels of activity than under coordination or competition with pre-commitment. Coordination can be futile, since it exacerbates the lack of credibility perceived by the private sectors.
Keywords: interdependence; policy coordination; precommitment; credibility; monetary policies; capital accumulation
JEL Codes: 023; 113; 431; 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monetary policy coordination under precommitment (E61) | reduction in the world real interest rate (E43) |
| reduction in the world real interest rate (E43) | increase in capital accumulation and output in both countries (E22) |
| increase in monetary growth rate (O42) | higher domestic inflation (E31) |
| higher domestic inflation (E31) | reduction in the world real interest rate (E43) |
| increase in monetary growth rate (O42) | stimulate capital accumulation in both countries (O24) |
| absence of precommitment (D10) | incentive to renegotiate policy announcements (E60) |
| incentive to renegotiate policy announcements (E60) | surprise inflation tax (H29) |
| surprise inflation tax (H29) | exacerbate inflation and reduce welfare (D69) |
| competitive policy formulation (L49) | excessive monetary growth rates (O42) |
| excessive monetary growth rates (O42) | harm economic welfare (D69) |