DP102 | The Sustainability of Optimal Cooperative Macroeconomic Policies in a Two-Country World

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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.