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causes a decline in American output of equally 30. The reduction in American
government purchases of 60 causes a decline in American output of 60. As a side
effect, it causes a decline in European output of equally 60. The total effect is a
decline in European output of 90 and a decline in American output of equally 90.
As a consequence, European output goes from 1030 to 940, and American output
goes from 1060 to 970. With this, European output and American output are back
at their initial levels. That means, this process will repeat itself step by step.
Table 8.5 presents a synopsis.

What are the dynamic characteristics of this process? There is an upward
trend in European government purchases. By contrast, there is a downward trend
in American government purchases. There are uniform oscillations in European
output, as there are in American output. The European economy oscillates
between unemployment and overemployment, as does the American economy.
There are repeated appreciations of the euro and repeated depreciations of the
dollar. Accordingly, there are repeated cuts in European exports and repeated
increases in American exports. Moreover, after a certain number of steps,
267

American government purchases are down to zero. As a result, the process of
fiscal competition does not lead to full employment.

4) Comparing fiscal competition with monetary competition. Monetary
competition can achieve full employment, but fiscal competition cannot do so.
Judging from this point of view, monetary competition is superior to fiscal
competition.

Table 8.5
Fiscal Competition between Europe and America
Unemployment in Europe and America

America
Europe

Initial Output 970
940
60 30
Change in Government Purchases
1060
Output 1030
Change in Government Purchases -60
-30
Output 970
940
and so on

1.4. Fiscal Cooperation between Europe and America

1) The model. At the beginning there is unemployment in both Europe and
America. More precisely, unemployment in Europe exceeds unemployment in
America. The targets of fiscal cooperation are full employment in Europe and
full employment in America. The instruments of fiscal cooperation are European
government purchases and American government purchases. So there are two
268

targets and two instruments. As a result, there is no solution to fiscal cooperation.
In other words, fiscal cooperation cannot achieve full employment in Europe and
America. The underlying reason is the large external effect of fiscal policy.

2) A numerical example. Let initial output in Europe be 940, and let initial
output in America be 970. In this case, the specific target of fiscal cooperation is
full employment in America. Aiming for full employment in Europe would
imply overemployment in America and, hence, inflation in America. So what is
needed is an increase in American output of 30. What is needed, for instance, is
an increase in European government purchases of 15 and an increase in
American government purchases of equally 15. The increase in European
government purchases of 15 raises European output and American output by 15
each. Similarly, the increase in American government purchases of 15 raises
American output and European output by 15 each. The total effect is an increase
in European output of 30 and an increase in American output of equally 30. As a
consequence, European output goes from 940 to 970, and American output goes
from 970 to 1000. In Europe unemployment comes down, but there is still some
unemployment left. In America there is now full employment. As a result, in this
case, fiscal cooperation can reduce unemployment in Europe and America to a
certain extent. On the other hand, fiscal cooperation cannot achieve full
employment in both Europe and America. Table 8.6 gives an overview.

Table 8.6
Fiscal Cooperation between Europe and America
Unemployment in Europe and America

Europe America

Initial Output 970
940
Change in Government Purchases 15 15
Output 970 1000
269

3) Comparing fiscal cooperation with fiscal competition. Fiscal competition
cannot achieve full employment. The same is true of fiscal cooperation. Fiscal
competition cannot reduce unemployment. Fiscal cooperation can reduce
unemployment to a certain extent. Under fiscal competition there is a tendency
for government purchases to explode. And there is a tendency for output to
oscillate uniformly. Under fiscal cooperation there are no such tendencies.
Judging from these points of view, fiscal cooperation seems to be superior to
fiscal competition.

4) Comparing fiscal cooperation with monetary cooperation. Monetary
cooperation can achieve full employment. By contrast, fiscal cooperation cannot
achieve full employment. From this perspective, monetary cooperation is
superior to fiscal cooperation.

1.5. The Anticipation of Policy Spillovers

The focus here is on monetary competition between Europe and America. To
illustrate this, have a look at a numerical example. An increase in European
money supply of 100 causes an increase in European output of 300 and a decline
in American output of 100. Similarly, an increase in American money supply of
100 causes an increase in American output of 300 and a decline in European
output of 100. Further let full-employment output in Europe be 1000, and let full-
employment output in America be the same.

Let initial output in Europe be 940, and let initial output in America be 970.
Steps 1, 2 and 3 refer to a series of policy responses. Then step 4 refers to the
output lag. Let us begin with step 1. The output gap in Europe is 60. The
monetary policy multiplier in Europe is 3. So what is needed in Europe is an
increase in European money supply of 20. The output gap in America is 30. The
monetary policy multiplier in America is 3. So what is needed in America is an
increase in American money supply of 10.
270

In step 2, the European central bank anticipates the effect of the increase in
American money supply. And the American central bank anticipates the effect of
the increase in European money supply. The European central bank expects that,
due to the increase in American money supply of 10, European output will only
rise to 990. And the American central bank expects that, due to the increase in
European money supply of 20, American output will only rise to 980. The
expected output gap in Europe is 10. The monetary policy multiplier in Europe is
3. So what is needed in Europe is an increase in European money supply of 3.3.
The expected output gap in America is 20. The monetary policy multiplier in
America is 3. So what is needed in America is an increase in American money
supply of 6.7.

We now come to step 3. The European central bank expects that, due to the
increase in American money supply of 6.7, European output will only rise to
993.3. And the American central bank expects that, due to the increase in
European money supply of 3.3, American output will only rise to 996.7. The
expected output gap in Europe is 6.7. The monetary policy multiplier in Europe
is 3. So what is needed in Europe is an increase in European money supply of
2.2. The expected output gap in America is 3.3. The monetary policy multiplier
in America is 3. So what is needed in America is an increase in American money
supply of 1.1.

Step 4 refers to the output lag. The accumulated increase in European money
supply of 25.6 causes an increase in European output of 76.7. As a side effect, it
causes a decline in American output of 25.6. The accumulated increase in
American money supply of 17.8 causes an increase in American output of 53.3.
As a side effect, it causes a decline in European output of 17.8. The net effect is
an increase in European output of 58.9 and an increase in American output of
27.8. As a consequence, European output goes from 940 to 998.9, and American
output goes from 970 to 997.8. For a synopsis see Table 8.7. As a result, the
anticipation of policy spillovers speeds up the process of monetary competition.

Finally compare monetary competition and monetary cooperation, given
anticipation. Monetary competition can achieve full employment. The same is
true of monetary cooperation. Monetary competition is a fast process. Again, the
same is true of monetary cooperation. From these points of view, there seems to
be no need for monetary cooperation.
271

Table 8.7
Monetary Competition between Europe and America
The Anticipation of Policy Spillovers

Europe America

Initial Output 940 970
Change in Money Supply 20 10
Change in Money Supply 3.3 6.7
Change in Money Supply 2.2 1.1
Output 998.9 997.8

2. Imperfect Capital Mobility
2.1. Fiscal Competition between Europe and America

1) The static model. In this section we assume imperfect capital mobility
between Europe and America. Under perfect capital mobility, an increase in
European government purchases raises both European output and American
output, to the same extent respectively. Under zero capital mobility, an increase
in European government purchases raises European output to a much larger
degree. On the other hand, it has no effect on American output. Under imperfect
capital mobility, an increase in European government purchases raises both
European output and American output. However, the rise in European output is
relatively large, and the rise in American output is relatively small.

To illustrate this, consider a numerical example. Under perfect capital
mobility, an increase in European government purchases of 100 causes an
increase in European output of 100 and an increase in American output of
272

equally 100. Under zero capital mobility, by contrast, an increase in European
government purchases of 100 causes an increase in European output of 200 and
an increase in American output of zero. On this basis we assume that, under
imperfect capital mobility, an increase in European government purchases of 100
causes an increase in European output of 150 and an increase in American output
of 50. That means, under perfect capital mobility, fiscal spillovers are very large.
Under zero capital mobility, fiscal spillovers are zero. And under imperfect
capital mobility, fiscal spillovers are medium size.

2) The dynamic model. At the beginning there is unemployment in both
Europe and America. The target of the European government is full employment
in Europe. The European government raises European government purchases so
as to close the output gap in Europe. The target of the American government is
full employment in America. The American government raises American
government purchases so as to close the output gap in America. We assume that
the European government and the American government decide simultaneously
and independently. As a result, under imperfect capital mobility, there is a stable
steady state of fiscal competition. In other words, fiscal competition leads to full
employment in Europe and America.

3) A numerical example. An increase in European government purchases of
100 causes an increase in European output of 150 and an increase in American
output of 50. Correspondingly, an increase in American government purchases of
100 causes an increase in American output of 150 and an increase in European
output of 50. Further let full-employment output in Europe be 1000, and let full-
employment output in America be the same.

Let initial output in Europe be 940, and let initial output in America be 970.
Step 1 refers to the policy response. The output gap in Europe is 60. The fiscal
policy multiplier in Europe is 1.5. So what is needed in Europe is an increase in
European government purchases of 40. The output gap in America is 30. The
fiscal policy multiplier in America is 1.5. So what is needed in America is an
increase in American government purchases of 20.

Step 2 refers to the output lag. The increase in European government
purchases of 40 causes an increase in European output of 60. As a side effect, it
causes an increase in American output of 20. The increase in American
273

government purchases of 20 causes an increase in American output of 30. As a
side effect, it causes an increase in European output of 10. The total effect is an
increase in European output of 70 and an increase in American output of 50. As a
consequence, European output goes from 940 to 1010, and American output goes
from 970 to 1020.

Step 3 refers to the policy response. The inflationary gap in Europe is 10. The
fiscal policy multiplier in Europe is 1.5. So what is needed in Europe is a
reduction in European government purchases of 6.7. The inflationary gap in
America is 20. The fiscal policy multiplier in America is 1.5. So what is needed
in America is a reduction in American government purchases of 13.3.

Step 4 refers to the output lag. The reduction in European government
purchases of 6.7 causes a decline in European output of 10. As a side effect, it
causes a decline in American output of 3.3. The reduction in American
government purchases of 13.3 causes a decline in American output of 20. As a
side effect, it causes a decline in European output of 6.7. The total effect is a
decline in European output of 16.7 and a decline in American output of 23.3. As
a consequence, European output goes from 1010 to 993.3, and American output
goes from 1020 to 996.7. And so on. Table 8.8 presents a synopsis.

Table 8.8
Fiscal Competition between Europe and America
Imperfect Capital Mobility

Europe America

Initial Output 940 970
Change in Government Purchases 40 20
1020
Output 1010
Change in Government Purchases -13.3
-6.7
993.3 996.7
Output
and so on
274

What are the dynamic characteristics of this process? There are damped
oscillations in European government purchases, as there are in American
government purchases. There are damped oscillations in European output, as
there are in American output. As a result, the process of fiscal competition leads
to full employment.

Taking the sum over all periods, the increase in European government
purchases is 37.5, and the increase in American government purchases is 7.5.
The total increase in European government purchases is small, as compared to
the initial output gap in Europe of 60. And the total increase in American
government purchases is even smaller, as compared to the initial output gap in
America of 30. The effective multiplier in Europe is 60/37.5 = 1.6, and the
effective multiplier in America is 30/7.5 = 4. That is to say, the effective
multiplier in Europe is large, and the effective multiplier in America is even
larger.

4) Comparing imperfect capital mobility with perfect capital mobility. Under
perfect capital mobility, fiscal competition does not lead to full employment.
Under imperfect capital mobility, by contrast, fiscal competition does lead to full
employment.

2.2. Fiscal Cooperation between Europe and America

1) The model. At the start there is unemployment in both Europe and
America. The targets of fiscal cooperation are full employment in Europe and
full employment in America. The instruments of fiscal cooperation are European
government purchases and American government purchases. So there are two
targets and two instruments. As a result, under imperfect capital mobility, there is
a solution to fiscal cooperation. In other words, fiscal cooperation can achieve
full employment in Europe and America. The required increase in European
government purchases depends on the initial output gap in Europe, the initial
output gap in America, the direct multiplier, and the cross multiplier. The larger
275

the initial output gap in Europe, the larger is the required increase in European
government purchases. Moreover, the larger the initial output gap in America,
the smaller is the required increase in European government purchases. At first
glance this comes as a surprise. The required increase in American government
purchases depends on the initial output gap in America, the initial output gap in
Europe, the direct multiplier, and the cross multiplier. It is worth pointing out
here that the solution to fiscal cooperation is identical to the steady state of fiscal
competition.

2) A numerical example. Let initial output in Europe be 940, and let initial
output in America be 970. The output gap in Europe is 60, and the output gap in
America is 30. What is needed, then, is an increase in European government
purchases of 37.5 and an increase in American government purchases of 7.5. The
increase in European government purchases of 37.5 raises European output by
56.25 and American output by 18.75. The increase in American government
purchases of 7.5 raises American output by 11.25 and European output by 3.75.
The total effect is an increase in European output of 60 and an increase in
American output of 30. As a consequence, European output goes from 940 to
1000, and American output goes from 970 to 1000. In Europe there is now full
employment, and the same holds for America. As a result, fiscal cooperation can
achieve full employment. The required increase in government purchases is
small, as compared to the initial output gap. Table 8.9 gives an overview.

Table 8.9
Fiscal Cooperation between Europe and America
Imperfect Capital Mobility

America
Europe

970
940
Initial Output
Change in Government Purchases 7.5
37.5
1000
Output 1000
276

3) Comparing imperfect capital mobility with perfect capital mobility. Under
perfect capital mobility, fiscal cooperation cannot achieve full employment.
Under imperfect capital mobility, by contrast, fiscal cooperation can indeed
achieve full employment.

4) Comparing fiscal cooperation with fiscal competition, given imperfect
capital mobility. Fiscal competition can achieve full employment. The same
applies to fiscal cooperation. Fiscal competition is a slow process. On the other
hand, fiscal cooperation is a fast process. Judging from these points of view,
fiscal cooperation seems to be superior to fiscal competition.

2.3. Monetary Competition between Europe and America

1) The static model. To illustrate this, consider a numerical example. Under
perfect capital mobility, an increase in European money supply of 100 causes an
increase in European output of 300 and a decline in American output of 100.
Under zero capital mobility, by contrast, an increase in European money supply
of 100 causes an increase in European output of 200 and a decline in American
output of zero. On this basis we assume that, under imperfect capital mobility, an
increase in European money supply of 100 causes an increase in European output
of 250 and a decline in American output of 50. That means, under high capital
mobility, monetary spillovers are large. On the other hand, under zero capital
mobility, monetary spillovers are zero. And under low capital mobility, monetary
spillovers are small.

2) The dynamic model. At the beginning there is unemployment in both
Europe and America. The target of the European central bank is full employment
in Europe. The European central bank raises European money supply so as to
close the output gap in Europe. The target of the American central bank is full
employment in America. The American central bank raises American money
supply so as to close the output gap in America. We assume that the European
central bank and the American central bank decide simultaneously and
277

independently. As a result, imperfect capital mobility speeds up the process of
monetary competition.

3) Comparing monetary competition with fiscal competition. Monetary
competition leads to full employment. The same is true of fiscal competition.
Monetary competition is a relatively fast process. By contrast, fiscal competition
is a relatively slow process. Judging from this perspective, monetary competition
seems to be superior to fiscal competition.

2.4. Monetary and Fiscal Cooperation

This section deals with cooperation between the European central bank, the
American central bank, the European government, and the American
government. At the start there is unemployment in Europe as well as America.
The targets of policy cooperation are full employment in Europe and full
employment in America. The instruments of policy cooperation are European
money supply, American money supply, European government purchases, and
American government purchases. There are two targets and four instruments, so
there are two degrees of freedom. As a result, there is an infinite number of
solutions. In other words, monetary and fiscal cooperation can achieve full
employment in Europe and America.

Of course there are many more potential targets of policy cooperation:
balancing the budget in Europe, balancing the budget in America, balancing the
current account in Europe and America, high investment in Europe, high
investment in America, preventing foreign exchange bubbles, preventing stock
market bubbles, and so on. To sum up, in a sense, policy instruments are
abundant. And in another sense, policy instruments are scarce.
278

1) Fiscal competition between Europe and America. So far we have assumed
that the governments follow a cold-turkey strategy. Now we assume that the
mobility between Europe and America. At the beginning there is unemployment
in Europe and America. The general target of the European government is full
employment in Europe. We assume that the European government follows a
gradualist strategy. The specific target of the European government is to close the
output gap in Europe by the fraction A^. The general target of the American
government is full employment in America. We assume that the American
government follows a gradualist strategy. The specific target of the American
government is to close the output gap in America by the fraction X2. We assume
that the European government and the American government decide
simultaneously and independently.

As a result, under a gradualist strategy, fiscal competition is a relatively fast
process. By contrast, under a cold-turkey strategy, fiscal competition is a
relatively slow process. At first glance this comes as a surprise. Moreover, under
a gradualist strategy, there are repeated increases in output. On the other hand,
under a cold-turkey strategy, there are oscillations in output.

2) Monetary competition between Europe and America. So far we have
assumed that the central banks follow a cold-turkey strategy. Now we assume
that the central banks follow a gradualist strategy. Besides we assume perfect
capital mobility between Europe and America. At the start there is
unemployment in Europe and America. The general target of the European
central bank is full employment in Europe. We assume that the European central
bank follows a gradualist strategy. The specific target of the European central
bank is to close the output gap in Europe by the fraction \i1. The general target of
the American central bank is full employment in America. We assume that the
American central bank follows a gradualist strategy. The specific target of the
American central bank is to close the output gap in America by the fraction [i2.
We assume that the European central bank and the American central bank decide
simultaneously and independently. As a result, under a gradualist strategy,
279

monetary competition is a relatively slow process. By contrast, under a cold-
turkey strategy, monetary competition is a relatively fast process.

3) Monetary and fiscal competition. This section deals with competition
between the European central bank, the American central bank, the European
government, and the American government. We assume imperfect capital
mobility between Europe and America. At the beginning there is unemployment
in Europe and America. The specific target of the European central bank is to
close the output gap in Europe by the fraction \il. The specific target of the
American central bank is to close the output gap in America by the fraction |i 2 â€¢
The specific target of the European government is to close the output gap in
Europe by the fraction X1. The specific target of the American government is to
close the output gap in America by the fraction X2. We assume that the European
central bank, the American central bank, the European government, and the
American government decide simultaneously and independently.

As a result, there is a stability condition. The steady state of monetary and
fiscal competition is stable if the speed of adjustment in European money supply,
American money supply, European government purchases, and American
government purchases is sufficiently low. Taking the sum over all periods, the
increase in European money supply, American money supply, European
government purchases, and American government purchases depends upon the
relative speed of adjustment in European money supply, American money
supply, European government purchases, and American government purchases.

4. The World of Three Monetary Regions

1) Monetary competition between Europe, America and Asia. The world
consists of three monetary regions, say Europe, America and Asia. The monetary
regions are the same size and have the same behavioural functions. At the
beginning there is unemployment in each of the regions. As a result, the steady
state is stable if and only if the internal effect of monetary policy is larger than
280

the external effect of monetary policy. This condition is fulfilled. In other words,
the process of monetary competition leads to full employment in each of the
regions. Now compare the world of three regions with the world of two regions.
In the world of two regions, monetary competition is a relatively fast process. By
contrast, in the world of three regions, monetary competition is a relatively slow
process.

2) Monetary cooperation between Europe, America and Asia. As a result,
there is a solution to monetary cooperation. That is to say, monetary cooperation
can achieve full employment in each of the regions.

3) Fiscal competition: perfect capital mobility. As a result, there is no steady
state of fiscal competition. In other words, the process of fiscal competition does
not lead to full employment. The underlying reason is the large external effect of
fiscal policy. Moreover, compare the world of three regions with the world of
two regions. In the world of two regions, fiscal competition causes uniform
oscillations in government purchases and output. By contrast, in the world of
three regions, fiscal competition causes explosive oscillations in government
purchases and output.

4) Fiscal competition: imperfect capital mobility. As a result, under low
capital mobility, fiscal competition is a stable process. However, under high
capital mobility, fiscal competition is an unstable process. That means, under low
capital mobility, fiscal competition leads to full employment. On the other hand,
under high capital mobility, fiscal competition does not lead to full employment.

5) Fiscal competition: gradualist policies. We assume high capital mobility.
As a result, fiscal competition is a stable process. In other words, fiscal
competition leads to full employment. Judging from this perspective, the
gradualist strategy seems to be superior to the cold-turkey strategy.

6) Fiscal cooperation: perfect capital mobility. As a result, there is no solution
to fiscal cooperation. That is to say, fiscal cooperation cannot achieve full
employment in each of the regions. The underlying reason is the large external
effect of fiscal policy.
281

7) Fiscal cooperation: imperfect capital mobility. As a result, there is a
solution to fiscal cooperation. In other words, fiscal cooperation can indeed
achieve full employment in each of the regions. Finally compare fiscal
cooperation with fiscal competition. Fiscal competition can achieve full
employment, provided capital mobility is sufficiently low. By contrast, fiscal
cooperation can achieve full employment in any case.

5. Rational Policy Expectations

1) Monetary competition between Europe and America. At the beginning
there is unemployment in both Europe and America. The target of the European
central bank is full employment in Europe. The instrument of the European
central bank is European money supply. The target of the American central bank
is full employment in America. The instrument of the American central bank is
American money supply. We assume that the European central bank and the
American central bank decide simultaneously and independently.

The European central bank sets European money supply, forming rational
expectations of American money supply. And the American central bank sets
American money supply, forming rational expectations of European money
supply. That is to say, the European central bank sets European money supply,
predicting American money supply by means of the model. And the American
central bank sets American money supply, predicting European money supply by
means of the model. As a result, there is an immediate equilibrium of monetary
competition. In other words, monetary competition leads to full employment
immediately. It is worth pointing out here that the equilibrium under rational

Here a comment is in place. The European central bank closely observes the
measures taken by the American central bank. And what is more, the European
central bank can respond immediately to the measures taken by the American
central bank. The other way round, the American central bank closely observes
282

the measures taken by the European central bank. And what is more, the
American central bank can respond immediately to the measures taken by the
European central bank. Therefore rational policy expectations seem not to be
very important.

2) Fiscal competition: perfect capital mobility. This section deals with fiscal
competition between Europe and America. At the beginning there is
unemployment in each of the regions. The target of the European government is
full employment in Europe. The instrument of the European government is
European government purchases. The target of the American government is full
employment in America. The instrument of the American government is
American government purchases. We assume that the European government and
the American government decide simultaneously and independently.

The European government sets European government purchases, forming
rational expectations of American government purchases. And the American
government sets American government purchases, forming rational expectations
of European government purchases. That is to say, the European government sets
European government purchases, predicting American government purchases by
means of the model. And the American government sets American government
purchases, predicting European government purchases by means of the model.
As a result, there is no equilibrium of fiscal competition. In other words, fiscal
competition does not lead to full employment. The underlying reason is the large
spillover effect of fiscal policy.

3) Fiscal competition: imperfect capital mobility. As a result, there is an
immediate equilibrium of fiscal competition. In other words, fiscal competition
leads to full employment immediately. It is worth pointing out here that the
equilibrium under rational expectations is identical to the steady state under
adaptive expectations. Now compare fiscal competition with monetary
competition. Fiscal competition can cause large changes in government
purchases. By contrast, monetary competition cannot cause any changes in
government purchases. Judging from this point of view, monetary competition
seems to be superior to fiscal competition.

4) Monetary and fiscal competition. This section deals with competition
between the European central bank, the American central bank, the European
283

government, and the American government. We assume imperfect capital
mobility. The target of the European central bank is full employment in Europe.
The target of the American central bank is full employment in America. The
target of the European government is full employment in Europe. And the target
of the American government is full employment in America. We assume that the
European central bank, the American central bank, the European government,
and the American government decide simultaneously and independently.

The European central bank sets European money supply, forming rational
expectations of American money supply, European government purchases, and
American government purchases. The American central bank sets American
money supply, forming rational expectations of European money supply,
American government purchases, and European government purchases. The
European government sets European government purchases, forming rational
expectations of American government purchases, European money supply, and
American money supply. The American government sets American government
purchases, forming rational expectations of European government purchases,
American money supply, and European money supply. As a result, there is no
unique equilibrium of monetary and fiscal competition. In other words, monetary
and fiscal competition does not lead to full employment.
Result
1. Monetary Competition between Europe and America

1) The static model. The world consists of two monetary regions, say Europe
and America. The monetary regions are the same size and have the same
behavioural functions. An increase in European money supply raises European
output. On the other hand, it lowers American output. Here the rise in European
output exceeds the fall in American output, as is well known. Correspondingly,
an increase in American money supply raises American output. On the other
hand, it lowers European output. Here the rise in American output exceeds the
fall in European output. In the numerical example, an increase in European
money supply of 100 causes an increase in European output of 300 and a decline
in American output of 100. Similarly, an increase in American money supply of
100 causes an increase in American output of 300 and a decline in European
output of 100. That is to say, the internal effect of monetary policy is very large,
and the external effect of monetary policy is large.

2) The dynamic model. At the beginning there is unemployment in both
Europe and America. The target of the European central bank is full employment
in Europe, and the instrument is European money supply. The European central
bank raises European money supply so as to close the output gap in Europe. The
target of the American central bank is full employment in America, and the
instrument is American money supply. The American central bank raises
American money supply so as to close the output gap in America. We assume
that the European central bank and the American central bank decide
simultaneously and independently. In addition there is an output lag. As a result,
the process of monetary competition is stable. In other words, monetary
competition leads to full employment in Europe and America.

3) A numerical example. Let full-employment output in Europe be 1000, and
let full-employment output in America be the same. Let initial output in Europe
be 940, and let initial output in America be 970. Step 1 refers to the policy
response. What is needed in Europe is an increase in European money supply of
20. And what is needed in America is an increase in American money supply of
286

10. Step 2 refers to the output lag. The net effect is an increase in European
output of 50 and an increase in American output of 10. As a consequence,
European output goes to 990, and American output goes to 980. In step 3,
European money supply is raised by 3.3, and American money supply is raised
by 6.7. In step 4, European output goes to 993.3, and American output goes to
996.7. And so on. There are repeated increases in European money supply, as
there are in American money supply. There are repeated increases in European
output, as there are in American output.

4) Another numerical example. At the start there is overemployment and
hence inflation. Let initial output in Europe be 1060, and let initial output in
America be 1030. The target of the European central bank is price stability in
Europe. The target of the American central bank is price stability in America.
Step 1 refers to the policy response. What is needed in Europe is a reduction in
European money supply of 20. And what is needed in America is a reduction in
American money supply of 10. Step 2 refers to the output lag. The net effect is a
decline in European output of 50 and a decline in American output of 10. As a
consequence, European output goes to 1010, and American output goes to 1020.
In step 3, European money supply is lowered by 3.3, and American money
supply is lowered by 6.7. In step 4, European output goes to 1006.7, and
American output goes to 1003.3. And so on. There are repeated cuts in European
money supply, as there are in American money supply. There are repeated cuts in
European output, as there are in American output. As a result, the process of
monetary competition leads to full employment and price stability.

2. Monetary Cooperation between Europe and America

1) The model. At the beginning there is unemployment in both Europe and
America. The targets of monetary cooperation are full employment in Europe
and full employment in America. The instruments of monetary cooperation are
European money supply and American money supply. So there are two targets
and two instruments. As a result, there is a solution to monetary cooperation. In
287

other words, monetary cooperation can achieve full employment in Europe and
America.

2) Some numerical examples. It proves useful to study two distinct cases.
First consider unemployment in Europe and America. Let initial output in Europe
be 940, and let initial output in America be 970. What is needed, then, is an
increase in European money supply of 26.25 and an increase in American money
supply of 18.75. The net effect is an increase in European output of 60 and an
increase in American output of 30. As a consequence, European output goes to
1000, as does American output. Second consider inflation in Europe and
America. Let initial output in Europe be 1060, and let initial output in America
be 1030. The targets of monetary cooperation are price stability in Europe and
price stability in America. What is needed, then, is a reduction in European
money supply of 26.25 and a reduction in American money supply of 18.75. The
net effect is a decline in European output of 60 and a decline in American output
of 30. As a consequence, European output goes to 1000, as does American
output. As a result, monetary cooperation can achieve full employment and price
stability.

3) Comparing monetary cooperation with monetary competition. Monetary
competition is a slow process. By contrast, monetary cooperation is a fast
process. Judging from this perspective, monetary cooperation seems to be
superior to monetary competition.

3. Fiscal Competition: Perfect Capital Mobility

1) The static model. An increase in European government purchases raises
both European output and American output. And what is more, the rise in
European output equals the rise in American output. Correspondingly, an
increase in American government purchases raises both American output and
European output. And what is more, the rise in American output equals the rise
in European output. In the numerical example, an increase in European
288

government purchases of 100 causes an increase in European output of 100 and
an increase in American output of equally 100. Likewise, an increase in
American government purchases of 100 causes an increase in American output of
100 and an increase in European output of equally 100. In a sense, the internal
effect of fiscal policy is rather small, whereas the external effect of fiscal policy
is quite large.

2) The dynamic model. At the beginning there is unemployment in both
Europe and America. The target of the European government is full employment
in Europe, and the instrument is European government purchases. The European
government raises European government purchases so as to close the output gap
in Europe. The target of the American government is full employment in
America, and the instrument is American government purchases. The American
government raises American government purchases so as to close the output gap
in America. We assume that the European government and the American
government decide simultaneously and independently. In addition there is an
output lag. As a result, the process of fiscal competition is unstable. In other
words, fiscal competition does not lead to full employment in Europe and
America. The underlying reason is the large external effect of fiscal policy.

3) A numerical example. Let full-employment output in Europe be 1000, and
let full-employment output in America be the same. Let initial output in Europe
be 940, and let initial output in America be 970. Step 1 refers to the policy
response. What is needed in Europe is an increase in European government
purchases of 60. And what is needed in America is an increase in American
government purchases of 30. Step 2 refers to the output lag. The total effect is an
increase in European output of 90 and an increase in American output of equally
90. As a consequence, European output goes to 1030, and American output goes
to 1060. In step 3, European government purchases are lowered by 30, and
American government purchases are lowered by 60. In step 4, European output
goes to 940, and American output goes to 970. And so on.

There is an upward trend in European government purchases. By contrast,
there is a downward trend in American government purchases. There are uniform
oscillations in European output, as there are in American output. The European
economy oscillates between unemployment and overemployment, as does the
American economy. Moreover, after a certain number of steps, American
289

government purchases are down to zero. Finally compare fiscal competition with
monetary competition. Monetary competition leads to full employment. Fiscal
competition, however, does not lead to full employment. From this point of view,
monetary competition is superior to fiscal competition.

4. Fiscal Cooperation: Perfect Capital Mobility

At the beginning there is unemployment in both Europe and America. The
targets of fiscal cooperation are full employment in Europe and full employment
in America. The instruments of fiscal cooperation are European government
purchases and American government purchases. So there are two targets and two
instruments. As a result, there is no solution to fiscal cooperation. In other words,
fiscal cooperation cannot achieve full employment in Europe and America. The
underlying reason is the large external effect of fiscal policy.

Consider a numerical example. Let initial output in Europe be 940, and let
initial output in America be 970. In this case, the specific target of fiscal
cooperation is full employment in America. Aiming for full employment in
Europe would imply overemployment in America and, hence, inflation in
America. So what is needed is an increase in American output of 30. What is
needed, for instance, is an increase in European government purchases of 15 and
an increase in American government purchases of equally 15. The total effect is
an increase in European output of 30 and an increase in American output of
equally 30. As a consequence, European output goes to 970, and American
output goes to 1000. In Europe unemployment comes down, but there is still
some unemployment left. In America there is now full employment.

Now compare fiscal cooperation with monetary cooperation. Monetary
cooperation can achieve full employment. By contrast, fiscal cooperation cannot
achieve full employment. From this perspective, monetary cooperation is
superior to fiscal cooperation.
290

5. Fiscal Competition: Imperfect Capital Mobility

1) The static model. An increase in European government purchases raises
both European output and American output. Here the rise in European output
exceeds the rise in American output. Correspondingly, an increase in American
government purchases raises both American output and European output. Here
the rise in American output exceeds the rise in European output. In the numerical
example, an increase in European government purchases of 100 causes an
increase in European output of 150 and an increase in American output of 50.
Similarly, an increase in American government purchases of 100 causes an
increase in American output of 150 and an increase in European output of 50.

2) The dynamic model. The European government raises European
government purchases so as to close the output gap in Europe. The American
government raises American government purchases so as to close the output gap
in America. We assume that the European government and the American
government decide simultaneously and independently. As a result, the process of
fiscal competition is stable. In other words, fiscal competition leads to full
employment in Europe and America.

3) A numerical example. Let initial output in Europe be 940, and let initial
output in America be 970. Step 1 refers to the policy response. What is needed in
Europe is an increase in European government purchases of 40. And what is
needed in America is an increase in American government purchases of 20. Step
2 refers to the output lag. The total effect is an increase in European output of 70
and an increase in American output of 50. As a consequence, European output
goes to 1010, and American output goes to 1020. In step 3, European
government purchases are lowered by 6.7, and American government purchases
are lowered by 13.3. In step 4, European output goes to 993.3, and American
output goes to 996.7. And so on. There are damped oscillations in European
government purchases, as there are in American government purchases. There
are damped oscillations in European output, as there are in American output.
291

6. Fiscal Cooperation: Imperfect Capital Mobility

As a result, there is a solution to fiscal cooperation. In other words, fiscal
cooperation can achieve full employment in Europe and America. Consider a
numerical example. Let initial output in Europe be 940, and let initial output in
America be 970. What is needed, then, is an increase in European government
purchases of 37.5 and an increase in American government purchases of 7.5. The
total effect is an increase in European output of 60 and an increase in American
output of 30. As a consequence, European output goes to 1000, as does American
output. Now compare fiscal cooperation with fiscal competition. Fiscal
competition is a slow process. By contrast, fiscal cooperation is a fast process.

7. The Anticipation of Policy Spillovers

The focus here is on monetary competition between Europe and America. In
the numerical example, an increase in European money supply of 100 causes an
increase in European output of 300 and a decline in American output of 100. Let
initial output in Europe be 940, and let initial output in America be 970. Step 1
refers to the policy response. What is needed in Europe is an increase in
European money supply of 20. And what is needed in America is an increase in
American money supply of 10.

Step 2 refers to the anticipation of policy spillovers. The European central
bank expects that, due to the increase in American money supply of 10, European
output will only rise to 990. And the American central bank expects that, due to
the increase in European money supply of 20, American output will only rise to
980. So what is needed in Europe is an increase in European money supply of
3.3. And what is needed in America is an increase in American money supply of
6.7.
292

Step 3 refers to the output lag. The accumulated increase in European money
supply is 23.3, and the accumulated increase in American money supply is 16.7.
The net effect is an increase in European output of 53.3 and an increase in
American output of 26.7. As a consequence, European output goes to 993.3, and
American output goes to 996.7. As a result, the anticipation of policy spillovers
speeds up the process of monetary competition. Thus there seems to be no need
for monetary cooperation.
Symbols

Ai autonomous term for Europe
A2 autonomous term for America
Bj autonomous term for Europe
B2 autonomous term for America
Gx European government purchases (real)
G2 American government purchases (real)
Gf the expectation of European government purchases,
as formed by the American government
G2 the expectation of American government purchases,
as formed by the European government
M1 European money supply
M2 American money supply
Mf the expectation of European money supply,
as formed by the American central bank
M2 the expectation of American money supply,
as formed by the European central bank
Pl the price of European goods
P2 the price of American goods
l\ producer inflation in Europe
P2 producer inflation in America
W^ nominal wage rate in Europe
W2 nominal wage rate in America
Yj European output, European income (real)
Y2 American output, American income (real)
Y1 full-employment output in Europe
Y2 full-employment output in America

t time

a monetary policy multiplier (direct effect)
(3 monetary policy multiplier (cross effect)
Y fiscal policy multiplier (direct effect)
294

8 fiscal policy multiplier (cross effect)
8 wage policy multiplier (direct effect)
r\ wage policy multiplier (cross effect)
Xx speed of adjustment of European government purchases
X2 speed of adjustment of American government purchases
\Xi speed of adjustment of European money supply
\x2 speed of adjustment of American money supply
A difference operator
The Current Research Project

The present book is part of a larger research project on monetary union, see
Carlberg (1999, 2000, 2001, 2002, 2003, 2004). Volume two (2000) deals with
the scope and limits of macroeconomic policy in a monetary union. The leading
protagonists are the union central bank, national governments, and national trade
unions. Special emphasis is put on wage shocks and wage restraint. This book
develops a series of basic, intermediate and more advanced models. A striking
feature is the numerical estimation of policy multipliers. A lot of diagrams serve
to illustrate the subject in hand. The monetary union is an open economy with
high capital mobility. The exchange rate between the monetary union and the rest
of the world is flexible. The world interest rate can be exogenous or endogenous.
The union countries may differ in money demand, consumption, imports,
openness, or size.

Volume three (2001) explores the new economics of monetary union. It
carefully discusses the effects of shocks and policies on output and prices. Shocks
and policies are country-specific or common. They occur on the demand or
supply side. Countries can differ in behavioural functions. Wages can be fixed,
flexible, or slow. In addition, fixed wages and flexible wages can coexist. Take
for instance fixed wages in Germany and flexible wages in France. Or take fixed
wages in Europe and flexible wages in America. Throughout this book makes use
of the rate-of-growth method. This method, together with suitable initial
conditions, proves to be very powerful. Further topics are inflation and
disinflation. Take for instance inflation in Germany and price stability in France.
Then what policy is needed for disinflation in the union? And what will be the
dynamic effects on Germany and France?

Volume four (2002) deals with the causes and cures of inflation in a
monetary union. It carefully studies the effects of money growth and output
growth on inflation. The focus is on producer inflation, currency depreciation and
consumer inflation. For instance, what determines the rate of consumer inflation
in Europe, and what in America? Moreover, what determines the rate of
consumer inflation in Germany, and what in France? Further issues are real
depreciation, nominal and real interest rates, the growth of nominal wages, the
296

growth of producer real wages, and the growth of consumer real wages. Here
productivity growth and labour growth play significant roles. Another issue is
target inflation and required money growth. A prominent feature of this book is
microfoundations for a monetary union.

Volume five (2003) deals with the international coordination of economic
policy in a monetary union. It carefully discusses the process of policy
competition and the structure of policy cooperation. As to policy competition, the
focus is on competition between the union central bank, the German government,
and the French government. Similarly, as to policy cooperation, the focus is on
cooperation between the union central bank, the German government, and the
French government. The key questions are: Does the process of policy
competition lead to full employment and price stability? Can these targets be
achieved through policy cooperation? And is policy cooperation superior to
policy competition? Another topic is monetary competition / monetary co-
operation between Europe and America.

Volume six (2004) studies the interactions between monetary and fiscal
policies in the euro area. The policy makers are the union central bank, the
German government, the French government, and other governments. The policy
targets are price stability in the union, full employment in Germany, full
employment in France, etc. The policy instruments are union money supply,
German government purchases, French government purchases, etc. As a rule, the
spillovers of fiscal policy are negative. The policy makers follow either cold-
turkey or gradualist strategies. The policy decisions are taken sequentially or
simultaneously. Policy expectations are adaptive or rational. This book carefully
discusses the case for central bank independence and fiscal cooperation. Further
information about these books is given on the web-page:
http://carlberg.hsu-hh.de
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