Static and dynamic noncooperative fiscal policy games among major industrial countries

This paper represents an attempt to analyze strategic interactions among policymakers in major industrial countries and their usefulness in justifying recent developments in key macroeconomic variables as the current account balance and the dollar exchange rate. The paper fits in the category of macroeconomic policy coordination models and is motivated by the G-7's recent attempts for policy coordination. It uses the game-theoretic approach to fiscal policy but it differs from other theoretical studies in that (i) it analyzes a fiscal policy differential game and provides an explicit closed loop Nash equilibrium and (ii) it examines explicitly the relationship between the current account deficit and the budget deficit in a game-theory context.;In the first part, a two-country, fixed price, flexible exchange rates Mundell-Fleming model is used to form a one-shot, symmetric fiscal policy game. In response to an asymmetric demand shock, each country uses its budget deficit as a policy instrument in order to achieve a current account and a budget deficit target. The Nash noncooperative equilibrium is found and compared to the cooperative solution. It is concluded that both the domestic and foreign fiscal policies are less active in the Nash equilibrium than in the cooperative solution. Then, the model is modified by assuming perfect capital mobility and explicitly incorporating exchange rate expectations. Private investors are assumed to play a game against the policymaker by acting as Stackelberg followers. Using a two-period framework, it is shown that fiscal policy is time inconsistent and that social welfare can increase if the policymaker can credibly precommit to the private sector or if the two policymakers can coordinate their policies.;In the second part, structural dynamics are introduced in the model through the use of the stock of foreign assets that adjusts over time in response to policy changes. In this framework, a symmetric, two-country differential game is analyzed where each policymaker chooses the rate of growth of the budget deficit. For this game, using numerical techniques, a stable, closed loop memoryless Nash equilibrium is derived. The subgame perfect or time consistent strategies chosen under this equilibrium express the growth rate of the budget deficit as a linear function of the state variables of the system.