Working Paper: CEPR ID: DP2718
Authors: Pierre Mellabarral; Paolo Vitale
Abstract: Countries can repeatedly and opportunistically renegotiate the terms of agreements to which they can only complicitly assent. Therefore, when attempting to coordinate exchange rate policies, they continuously play partnership games. We develop a reduced form model of exchange rate management where, as a starting point, (a) sequences of discrete realignments and (b) shared intervention are desirable. We show that the implementation of the ex-ante optimal policy suffers from severe time-inconsistencies. We analyse the Stackelberg equilibria of the stochastic differential game played by partner countries. We find that equilibrium complicit renegotiation-proof policies are supported by net cross-country wealth transfers from the weaker to the stronger bargaining power country. Our theoretical results provide a game-theoretic interpretation of the evolution of monetary arrangements in Europe and the emergence of EMU.
Keywords: Bargaining Power; Cross-Country Wealth Transfers; Exchange Rate Management; Renegotiation
JEL Codes: C73; F31; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| bargaining power (C79) | ability to renegotiate exchange rate agreements (F33) |
| cross-country wealth transfers (H87) | efficiency of exchange rate policies (F31) |
| bargaining power (C79) | policy outcomes (D78) |
| wealth transfers (H24) | policy outcomes (D78) |
| absence of wealth transfers (D14) | divergence from first-best policy (H21) |
| cross-country wealth transfers (H87) | high inefficiencies (D61) |