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The failure to cooperate and coordinate macroeconomic policies will leave countries worse off than an outcome involving cooperation

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Introduction

The failure to cooperate and coordinate macroeconomic policies will leave countries worse off than an outcome involving cooperation Most countries around the world interest in international economic cooperation have increased substantially in recent years. This heightened desire to coordinate economic policies with the major economic power is in part a response to the special problems (e.g. the sharp fluctuation in exchange rates) and the changes in the world economy. The world economy has become more interdependent: international trade has increases relative to production for domestic markets and international capital markets have become larger and more active. The failure to cooperate and coordinate macroeconomic policies will leave countries worse off than an outcome involving cooperation. The basic theoretical model of interdependence is the two-country model developed by Robert Mundell (1963) and J. Marcus Fleming (1962). Then McKibbin and Sachs (1991) develop a multi-country model, which allows for flexible wages and prices and rational expectations. The basic two-country Mundell-Fleming model was the first to study macroeconomic interaction in a formal theoretical setting under the realistic assumption of high capital mobility between the 'home' and 'foreign' countries. This model examines the transmission of monetary and fiscal policies under different assumption about exchange rate flexibility, wage setting, and capital mobility. (See Table 1) First, consider the expansionary monetary policy. Under the floating exchange rates conditions, the domestic monetary expansion always causes a depreciation of the home currency and a rise in home output, and it ...read more.

Middle

In the absence of direct cooperation, it is well known that the outcomes of such games are socially inefficient; there are alternative policies that would make all parties better off. The benefits of coordination can be illustrated at a basic level using the famous prisoner's dilemma game. (See Table 2)This game is described as static in nature because the game relates to the domestic country and foreign country each trying to set the optimal level of their monetary policy in response to an inflationary shock. (Hallwood and MacDonald, 2000) And the issues are illustrated in the following using a diagram developed by Hamada (1979). Table 2. The Prisoner's Dilemma and the Nash-Cournot Equilibrium Figure 1 illustrates the loss function of each country define a set of indifference curves as ellipses in m1 and m2 space. Suppose each country wishes to minimize a loss function of the form: The indifferent curves have their particular shape because of the potential spillover from country 1 to country 2. Complete policy independence for the two countries in the diagram by vertical straight-line indifference curve for the home country and the horizontal straight line for the foreign country. All the bliss points at which the indifference curves are tangential will represent the efficient, or optimal, policies for the two countries. Using this Nash reaction function may be illustrated for country 1 using the geometric argument in the diagram. ...read more.

Conclusion

Differences in objectives between countries affect the basic principle of gains from cooperation. The ongoing nature of policy interactions among countries, reputational considerations make cooperative equilibrium more likely. (Barro, 1986)Each country knows it will be better off in the long run if the cooperative equilibrium is maintained. Countries may develop strategies both to punish those that do not cooperate, and to earn a reputation for reliability. It then becomes possible that countries will reach and stay at the cooperative equilibrium. Coordination through reputation, without explicit international agreements, is less likely the more countries there are. When everyone is at the cooperative equilibrium, the temptation for one small country to break ranks is very strong. The potential cost to it of doing so may also be high, for it is more dependent on the world economy than is a larger country. But because it inflicts very little damage on the rest of the world by not cooperating, it is not certain that it will be penalized. Finally, in the absence of coordination, policies which rely on reputation may be undesirable. (Currie et.al., 1987) This is because the government which has reputation can more readily affect market expectations, and the coordination failures, especially those relating to the exchange rate, that arise from the noncoordination of policies are more likely to be increased when a government has reputation. From all above issues, which discussed on policy coordination, considering the game theory relating to the optimality of cooperative strategies, then, make a convincing case that coordination is generally superior to noncooperative policy-making. ...read more.

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