S U P P L Y - P O L I C Y C O O R D I N A T I O N I N A M O N E T A R Y U N I O N

C a r m e n D í a z - R o l d á n *

Universidad de Castilla-La Mancha

Resumen: Se examina la forma en la que los estados miembros de una unión mo­netaria grande responden, tanto a perturbaciones especificas como a las procedentes del resto del mundo, utilizando políticas de oferta. Para ello desarrollamos un modelo de tres países, de los cuales dos cons­tituyen una unión monetaria donde un banco central independiente controla la política monetaria y las políticas de oferta son determinadas por las autoridades a nivel nacional. En este contexto, analizamos en términos estratégicos cómo las autoridades pueden hacer frente a per­turbaciones monetarias, reales y de oferta. Se discuten los aspectos de bienestar de la solución óptima, asi como hasta que punto la coor­dinación de las políticas de oferta puede ser útil para hacer frente a dichas perturbaciones.

[bstract: This paper examines how the member countries of a large monetary union react to country-specific shocks, and to shocks from the rest of the world, using supply-side policies. We develop a three-country model in which two of the countries form a monetary union where an independent central bank to control monetary policy, and supply-side policies are determined by the authorities at the national level. In this framework, we analyse in strategic terms how the authorities can deal with monetary, real and supply shocks, and discuss the welfare aspects of the optimal solution and the extent to which a coordinated supply-side policy may be useful to deal with those shocks.

7EL Classifications: E61, E62, F42 Vecha de recepción: 22 XI 2002 Fecha de aceptación: 17 III 2003

* I wish to thank Oscar Bajo-Rubio and Juan Francisco Jimeno for their help-il suggestions, and the participants at the XXVI Simposio de Análisis Económico Barcelona, 1999), and the 59th International Atlantic Economic Conference Charleston, South Carolina, 2000). Financial support from the Department of ducation and Culture of the Government of Navarra, as well as from the Span-h Ministry of Science and Technology, through the project SEC2002-01892, is so gratefully acknowledged. Of course, all the remaining errors are my own. irmen.diazroldan@uclm.es.

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164 E S T U D I O S ECONÓMICOS

1 . I n t r o d u c t i o n

The costs of losing the exchange rate and monetary pol icy as i n s t ru ­ments of macroeconomic s tabi l izat ion acquire a special impor tance when deciding the convenience of forming a monetary un ion . M o s t of the theoretical and empir ica l studies conclude tha t these costs w i l l depend on the asymmetry of the shocks. So, for instance, B a y o u m i and Eichengreen (1993) find tha t the costs imposed by asymmetr ic shocks i n the European monetary union w i l l be larger, since these shocks require country-specific adjustment policies.

Ano the r question broadly discussed is tha t , i n the absence of fu l ly flexible prices and wages, as wel l as labour mobi l i ty , as adjustment mechanisms, governments have to deal w i t h shocks using m a i n l y fiscal policy. B u t the disc ip l in ing effects of a monetary union may require some l imi ta t ions on the use of fiscal policy. We can ment ion , as an example, the fiscal discipline imposed by the Pact for S tab i l i ty and G r o w t h i n the European Moneta ry Union , EMU. Since fiscal po l icy in monetary unions may be inefficient, the possibi l i ty of fiscal pol icy co­ord ina t ion has been discussed; the conditions under which fiscal pol icy coordinat ion may be desirable are derived i n D í a z - R o l d á n , 2000a.

O n the other hand, given the l imi ta t ions of fiscal policy, i t w o u l d be desirable to have al ternative policies, among them, the possibi l i ty of using supply-side policies has been discussed (Jimeno, 1992; V i ñ a l s and Jimeno, 1998). F rom a different point of view, this possibi l i ty had been mentioned i n the l i tera ture on o p t i m u m currency areas: coun­tries w i t h s imilar inf la t ion rates would be good candidates to j o i n a common currency area, this feature being related to the s imilar­i ty o f the in s t i t u t iona l mechanisms of the labour market (Calmfors and D r i f f i l l , 1988). Th i s argument could support the need for some harmoniza t ion of the ins t i tu t iona l mechanisms governing the labour markets of the countries forming a monetary union, as an useful t o o l for reducing the cost of belonging to a common currency area.

The available l i tera ture has hardly studied supply-side policies. De M i g u e l and Sosvilla (2001) develop a two-country model in order to analyse the effects of macroeconomic policies i n a monetary un ion w i t h different wage r igidi t ies . Supply-side policies are represented by changes in the employers'social security contr ibut ions , wh ich has a direct impact on real wages. O n the other hand, Sibert and Suther­land (1997) develop an in ter tempora l n-country model to s tudy the role of long-run labour market reforms on the costs and benefits of monetary integrat ion. They conclude tha t i n a monetary union the degree of labour market reform required is lower than in other mone-

M O N E T A R Y UNION 165

t a ry pol icy regimes. More recently, D í a z - R o l d á n (2002) analyses the scope of shor t - run labour market intervent ion by means of a two-country model , before and after forming a "small" monetary un ion . The results show tha t coordinat ion of supply-side policies is desir­able when the effects of the shocks are different i n the economies involved. T h i s is pa r t i cu la r ly t rue for a l l demand shocks w i t h i n the no-monetary union case, and only for real shocks w i t h i n the mone­t a ry un ion case, bu t i n b o t h cases when the shocks are t r ansmi t t ed th rough the beggar-thy-neigbour effect.

I n th is paper we examine how the member countries of a mon­etary un ion can react to shocks by using supply-side policies. To this end, we extend the two-country model developed by D í a z - R o l d á n (2002) t o the three-country case where two of the countries f o r m a monetary un ion and the variables of the t h i r d count ry (the rest o f the wor ld ) are t reated as endogenous. I n this "large" monetary un ion an independent central bank controls monetary policy, there are some restrict ions on fiscal policy, and supply policies are determined by the authori t ies at the na t ional level. Next , we analyse i n strategic terms how the authori t ies of each member country can deal w i t h shocks using a supply-side variable which could be interpreted as i n ­s t i t u t i ona l in tervent ion i n the labour market . The authori t ies can act i nd iv idua l ly or cooperatively and, i n the rest of the paper, we ident i fy cooperat ion among authori t ies w i t h pol icy coordinat ion.

As an or iginal con t r ibu t ion of this paper, first of a l l , we can ment ion t h a t the model has been expl ic i t ly designed for a "large" monetary un ion , which is not frequent in the l i tera ture . Secondly, we analyse the role of supply-side policy, something tha t has also ha rd ly been discussed in the l i tera ture . A n impor t an t result derived f rom our analysis is t ha t the desirabi l i ty of supply-side pol icy coordina t ion is not only related t o the characteristics of the shocks, bu t also to the way i n which the i r effects are t r ansmi t t ed among countries. I n add i t ion , the role played by the channel of transmission of the shocks w i l l be determinant for the results. More precisely, the ma in result is t ha t in a "large" monetary union, supply-side pol icy coord ina t ion w o u l d be desirable when dealing w i t h real shocks wh ich have the i r o r ig in w i t h i n the union's country members, and wh ich are t r an smi t t ed th rough the beggar-thy-neigbour effect.

The paper is s t ructured as follows. F i rs t , a theoret ical mode l for a monetary union is developed, which w i l l allow us to s tudy the effects of shocks on the union's member countries. Next , the possibilit ies for supply-side pol icy coordinat ion among the monetary union's member countries are analysed in strategic terms. Final ly , section 4 concludes.

166 E S T U D I O S ECONÓMICOS

2. T h e o r e t i c a l F r a m e w o r k

We w i l l consider a model of two symmetr ic economies: the mone ta ry un ion and the rest of the w o r l d , w i t h flexible exchange rates and per­fect capi ta l m o b i l i t y between them. The monetary union is described by the fol lowing set of equations:

y = - a r w + + 0(ew + p* - p) + 6y* + / (1)

m - p — Oy - tprw (2)

pc = (1 - fi)p + p,(p* + ew) (3)

w — epc = 4>prod — nu + z — v — t (4)

p — w = —cpprod — (pu (5)

y = n + prod (6)

u — I — n (7)

A l l the variables are defined as rates of change, except r and u , w ich capture the instantaneous changes i n the interest rate, and i n the unemployment rate, respectively. A l l parameters, denoted by Greek letters, are nonnegative.

Equa t ion (1) represents the goods market equ i l ib r ium condi t ion . O u t p u t , y, depends on the world 's interest rate r w , the real exchange rate (defined f rom the nomina l exchange rate, e w , and the countries ' relative prices p and p*) , the other country 's ou tpu t , and a posi t ive real shock / .

Equa t ion (2) shows the money market equ i l ib r ium condi t ion , where m denotes the money supply, and money demand depends on demestic ou tpu t , and the wor ld interest rate.

Equations (3) to (7) represent the aggregate supply of the econ­omy, bu i l t along the lines of Layard, Nickell and Jackman (1991). F i r s t , equation (3) defines the consumer price index p c , as a weighted average of the prices of domestic and impor ted goods i n terms of the domestic currency.

M O N E T A R Y UNION 167

Equa t ion (4) shows tha t nomina l wages, w, are determined by the degree of indexat ion w i t h respect to the consumer price index, and depend on the parameter e\ labour p roduc t iv i ty , prod; the unem­ployment rate, u\ wage pressure factors, z\ the error in expectations, captured by the variable v\ and the use, as a pol icy instrument , of a supply-side variable it, wh ich could be used as a direct way of pol icy in tervent ion on the labour market . Note tha t the parameter e denotes the degree of wage r ig id i ty , w i t h 0 < e < 1; we w i l l assume here the intermediate case so tha t 0 < e < 1.

I n equation (5) , prices are set by adding a marg in to wages, wh ich depends on p roduc t iv i ty , prod, and the unemployment rate, u. We also assume tha t the parameter <f> is the same as i n the wage-setting equation (4) . This assumption, which simplifies the analysis w i t h o u t a l ter ing the basic results, is commonly used i n the l i terature , and is jus t i f ied since in the long t e r m p roduc t iv i t y changes do not affect the unemployment rate (see e.g. Layard , Nickel l and Jackman (1991)).

F ina l ly , equation (6) defines changes in ou tpu t as the sum of changes i n employment, n , and produc t iv i ty , prod. A n d equation (7) defines changes i n the unemployment rate, u, i n terms of active popula t ion , /, and employment , n.

The second economy analysed is the rest of the wor ld . As men­t ioned earlier, we develop a model for two symmetr ic economies; therefore, equations describing the rest of the wor ld are equivalent to the monetary union's equations:

y* = -ocrw - (3(ew + p* p) + 6y + f* (8)

* * /i * m — p = vy ipr. w (9)

Pc = (l - m ) p * + ^ ( p (10)

w* — ep* = 4>prod* — nu* -f z* — v* ( i i )

p* — w* = —(ftprod* — (pu* (12)

y* = 7i* -f* prod* (13)

u = I — n (14)

168 ESTUDIOS ECONÓMICOS

Note tha t i n the goods market equ i l ib r ium condi t ion , we neglect the fiscal variable g*, wh ich is i m p l i c i t l y included i n the real shock / * . We also neglect the in s t i t u t iona l variable £*, i m p l i c i t l y inc luded i n the supply shock s*(see below).

F r o m equations (1) to (7) for the monetary un ion and (8) t o (14) for the rest of the w o r l d , we can ob ta in the aggregate demand functions for each economy:

yd = , 1 A m -p)+ , ^ a (ew + P* - p) ip + av ip + ad

H +d . ^ a x ^ f (I*)

+ _ ! _ , . (16) ip + aO ip + aO

Combin ing the def in i t ion of the consumer price index (3) w i t h t he aggregate supply equations, (4) t o (7) , we can ob ta in the monetary union's aggregate supply:

ys = -X(e - l)p - Xefi(ew + p* - p) - \z + \v H- \t + I + prod

where A = — j — . T o simplify, we group a l l the exogenous supply shocks i n a con­

t rac t ionary disturbance s:

s — z — v I prod A A

where s embodies the negative effect on ou tpu t of an increase i n the degree of wage pressure, z\ and the posit ive effects o f increases i n expectations errors, v\ active popula t ion , /; and p roduc t iv i ty , prod.

Then , the aggregate supply of the union w i l l be:

ys = -\(e - l)p - \efi(ew + p* - p) - \s + \t (17)

and, i n a s imilar way, for the rest of the wor ld :

„ " = - A ( e - l ) p * + Xefi(ew + p* - p) - As* (18)

M O N E T A R Y UNION 169

where:

1 1 s — z — v — —/ proa

A A

2.1 . TTie Countries of the Union

We assume t h a t the monetary un ion is formed by two symmetr ic member countries denoted by 1 and 2.

The economic framework of the union's member countries is given by equivalent equations t o those of (1) t o (7) , for b o t h count ry 1 and count ry 2. However, i n order t o describe a monetary un ion , these two sets of equations are modif ied i n the fol lowing way: first, the nomina l exchange rate between countries 1 and 2 is made equal t o zero; and, second, b o t h countries replace each ind iv idua l money mar­ket equ i l i b r ium condi t ion by a common equ i l ib r ium condi t ion , w h i c h can be w r i t t e n as follows:

1 1 0 0 m - -pi - -p2 = + -2/2 ~ ^rw (19)

I n equat ion (19), m denotes the union's money supply, so the demand for money depends on the ou tpu t of the two countries, and the union's interest rate.

Note tha t , since the variables are i n rates of change, the variables of the monetary un ion are equal to the weighted sum of the member countries ' variables, and we can assume tha t thei r relative weights reflect the bargaining power of each count ry inside the union. T h a t is, for any variable x:

Yi Y2

x = —xx + — x2

where x,x\,x2 are the rates of change of variable x for the un ion , count ry 1, and count ry 2, respectively; Y,Y\,Y2 are the i r levels of ou tpu t , and Y\ + Y2 — Y. For convenience, we have assumed

Y Y 2'

So, f rom the weighted sum of the equations for country 1 and 2, we can ob ta in equations (1), and (3) to (7) for the monetary un ion .

170 E S T U D I O S ECONÓMICOS

2.2. The Transmission of the Shocks

F r o m equations (1) to (7) and (8) to (14), and assuming e q u i l i b r i u m i n the goods market : y3 = yd = y and y*s — y*d = y*, we can o b t a i n the reduced forms for the monetary un ion and the rest of the w o r l d : 1

y = aym ± bym* + cyg + dyf ± hyf* - iys - j y s * + i y t (20)

y* = aym* ± bym ± kyg + dyf* ± hyf - iys* - jys + jyt (21)

p = apm ± bpm* + cpg - f dpf + hpf* + ips + j p s * - ipt (22)

p* = apm* ± bpm + /cpp + rfp/* + hpf + i p s * + j p 5 - j p t (23)

Equations (20) to (23) show the interdependence between the two economies, given by the interact ion of the variables. O n the other hand, given t ha t the variables of the monetary un ion are equal to the weighted sum of the member countr ies 'variables, and tha t the in terac t ion t a k i n g place between t hem is equivalent to the in te rac t ion between the un ion and the rest of the wor ld , we could also rewr i te the preceding equations as follows:

The detailed derivation of all the equations in the paper, together with the definition of the coefficients, can be seen in Diaz-Roldan (2000b).

y I = aym ± b'ym* + cygi ± Cyg2 + d'yfi ± dyf2

±hyf " V 1 ~~ V 2 ~ h s + V 1 + V 2 (24)

2/2 = cbym ± bym* + cyg2 ± cyg\ + dyf2 ±'dy'fi

±hyf - l y S 2 - l y S l - JyS + Z y Í 2 H" ^ y ^ 1 (25)

y* = aym* ± bym ± k'yg\ ± kyg2 + dyf* ± h'yfi

MONETARY UNION 171

- iyS* ~ j'ySl - jyS2 + j'yti + (26)

Pi = apm ± b'pm* + c p p i + c p p 2 + d'pfi + d!pf2

+h'pf* + i ^ ! + i ^ a + ¿ ¿ 5 * - ifa - t ^ 2 (27)

p 2 = a p m ± + cpg2 + cp'<n + d p / 2 + d p ' / i

+ ^ p 7 * + V 2 + tpf l i + j ^ * - i'pt2 - t ^ x (28)

p* = apm* ± 6 p m + kpgi + kpg2 + dpf* + / i p / i

+ ^ p / 2 + iPs* + i p * i + i p « 2 ~ Jp*i ~ ip*2 (29)

The reduced form given by equations (24) to (29) shows the in terac t ion between the two countries of the union and the rest o f the wor ld . As can be seen, we have two kinds of monetary shocks: the monetary pol icy ins t rument of the union's monetary au tho r i t y (m) and monetary shocks f rom the rest of the w o r l d ( m * ) . O n the other hand, regarding real and supply shocks, we can observe shocks from each count ry of the union ( f\,f2,s\,s2), and the rest of the w o r l d

We f ind tha t a negative supply shock affecting one of the coun­tries of the union (51 ,52 > 0) or the rest of the wor ld ( 5 * > 0) , leads to an o u t p u t fall and a rise i n prices, b o t h in the union and i n the rest of the wor ld . Th i s effect is independent of the channel of t ransmis­sion and the or ig in of the shock. Regarding the ins t i t u t iona l supply variables o f the union's member countries (¿1,^2)» their effects have the same absolute value bu t the opposite sign as supply shocks.

I n t u r n , posi t ive demand shocks ( m , m * , g±, g2, / 1 , f2, / * > 0) lead to posit ive effects on the ou tpu t and prices of the coun t ry of or ig in of the shock. B u t when the shock is t r ansmi t t ed between the countries o f the union , and between each member count ry and the rest of the w o r l d , the sign of the coefficients depends on which channel of transmission prevails. I n our model , the channels of t ransmission of the demand shocks are aggregate demand, the interest rate, the real exchange rate between the union and the rest of the wor ld , and the monetary union's relative prices.

As mentioned before, when aggregate demand prevails, the result is the locomotive effect: the effects on ou tpu t and prices of the coun t ry of o r ig in of the shock are t r ansmi t t ed to the rest of the economies w i t h

172 E S T U D I O S ECONÓMICOS

the same sign. We find t h a t an aggregate demand expansion w i t h an o u t p u t expansion and a rise i n prices i n a l l the economies involved. B u t when changes i n the interest rate and the real exchange ra te prevai l , the result is the beggar-thy-neighbour effect: the effects on the o u t p u t and prices of the count ry of or ig in of the shock are t r a n s m i t t e d to the rest of the economies w i t h the opposite sign. T h e reason is t h a t a real exchange rate depreciation (appreciation) i n an economy leads to an aggregate demand expansion (contract ion) in tha t economy, and to a contract ion (expansion) i n the other, given tha t a depreciat ion (appreciat ion) i n one economy, implies an appreciation (depreciation) i n the other.

We have jus t shown the way i n which macroeconomic shocks af­fecting the monetary un ion and supply-side policies adopted by the member countries ' governments are t r ansmi t t ed between the coun­tries of the monetary un ion and the rest of the wor ld . The purpose of the next section w i l l be to show how in ternat ional pol icy coord ina t ion may internalize the po ten t ia l spillover effects.

3. S u p p l y P o l i c y C o o r d i n a t i o n i n a M o n e t a r y U n i o n

T h e theoret ical arguments suppor t ing pol icy coordinat ion are based on the idea t ha t cooperation internalizes the effects o f economic inter­dependence. I n this way, we need to take in to account the strategic behaviour of the authori t ies , so we w i l l use the Game Theory ap­proach i n order t o s tudy how the authori t ies can deal w i t h shocks.

We assume tha t countries 1 and 2 are represented by their au­thor i t ies , wh ich face the problem of m i n i m i z i n g thei r loss functions:

where the target variables are the rates of change of ou tpu t (2/1,2/2)? of the budget deficit (gi, 0 2 ) , and also of prices ( p i , ^ 2 ) - For th is purpose, the authori t ies w i l l use as a pol icy ins t rument an in s t i t u t i ona l variable (¿1 , ¿ 2 ) , affecting the process of wage set t ing. We also assume <j\ ^ a2

and tti ^ 7T2, so we consider asymmetric preferences. O n the other hand, the quadrat ic form of the loss funct ion implies t ha t any change, posi t ive or negative, i n the variables w i l l represent a loss of u t i l i t y . So, each count ry w i l l min imize its loss funct ion when a l l the objectives become equal t o zero: 2/1 — 2/2 = 0, g\ — 02 = 0, and y\—V2 — 0.

L \ = yj + o-\gi + nip* (30)

¿ 2 = V 2 +°~292 + 7 r 2P2 (31)

MONETARY UNION 173

The fact tha t the d isc ip l in ing effects of a monetary un ion i m p l y some restrict ions on fiscal pol icy allows us to include the budget deficit as an objective of the authori t ies . A n example of this s i tua t ion is the European monetary union, where each member count ry has to fu l f i l the budget deficit requirements of the Pact for S tab i l i ty and G r o w t h . I n this context , the price objective captures the cost of author i t ies ' in tervent ion i n terms of inf la t ion .

3 .1 . Welfare Aspects of the Optimal Solution

From a theoret ical po in t of view, the cooperative solut ion is Pareto improv ing since i t internalizes the spillover effects arising f rom eco­nomic interdependence. These externalities,

dL\ dL2

—— and ——, dt2 dti

show how the loss funct ion of a country changes in response to changes in the other country 's ins t rument .

O n the one hand, the first-order conditions from which we wou ld ob ta in the Nash E q u i l i b r i u m are

dL

dii

dL2

dt2

- = 0 and ^ = 0.

B u t for these points

3L_

dt2

i ^ O a n d ^ r dti

Given tha t we can w r i t e the social planner loss funct ion i n terms of the countries ' authori t ies loss functions,

L =

the first-order condit ions of the min imiza t i on problem wou ld be:

174 E S T U D I O S ECONÓMICOS

dL _ 1 / d L \ dL2

dt2 ~ 2 \lFh + #¿¡~ = 0 (33)

F rom these condit ions i t is clear t ha t

dLi dL2

dti and

dL2

dt2

dLi

dt2

w h i c h shows how the cooperative solut ion internalizes externali t ies. B u t the desirabi l i ty of the cooperative solut ion w i l l depend on the na ture of the external i ty. I f the external i ty has the same sign as the shock, the external i ty reinforces the effects of the shock. Sub­sequently, the cooperative solut ion requires a greater change of the pol icy ins t rument t h a n the compet i t ive solut ion. O n the contrary, when the external i ty shows a different sign than the shock, the coop­erative solut ion is the solut ion t ha t requires the lowest change.

I n order t o avoid the spillover effects of thei r policies, the coun­tr ies ' authori t ies w i l l t r y to min imize the use of the supply side va r i ­able. I n this sense, they identify s tabi l iza t ion w i t h avoiding changes i n the pol icy ins t rument . I n par t icular , we have modelled a loss funct ion i n w h i c h any change i n the variables implies a loss of u t i l i t y . Since the target variables are linear i n the pol icy instruments, the so lu t ion t h a t requires the smallest change i n the supply side variable w o u l d be the o p t i m a l solut ion. So, i n a first step, authori t ies w i l l m in imize the i r loss functions, and, i n a second step, they w i l l choose the solu­t i o n (compet i t ive or cooperative)leading to the lowest absolute value of the ins t rument :

3.2. Desirability of Coordination

Now we w i l l show the effects of the authori t ies ' decisions when cop­ing w i t h shocks. Each country of the monetary union has to m i n i ­mize i ts loss funct ion by choosing the op t ima l rate of change of the i n s t i t u t i ona l variable, subject to the restrictions imposed by the i n ­te rna t iona l economic framework. I n accordance w i t h Game Theory l i te ra ture , we w i l l focus our analysis on the comparison between the compet i t ive solut ion and the cooperative solut ion. I n any case, the solutions w i l l depend on the prevai l ing channel of transmission: the aggregate demand leading to the locomotive effect, or the interest rate and the real exchange rate leading to the beggar-thy-neighbour effect.

í < = m i n { | t j V | i | , | í c l i | } V ¿ = l , 2

M O N E T A R Y UNION 175

Afte r analysing the solutions for the two alternatives, we o b t a i n tha t (see D í a z - R o l d á n (2000b) for details):

a) For the locomotive effect case, i f the authori t ies act i n d i v i d ­ually, the solut ion requires a lower change i n the in s t i t u t iona l var i ­able t h a n i f they coordinate. T h i s result holds for real and monetary shocks, independently of the o r ig in of the shock ( f rom a country o f the un ion , i.e.: a country-specific shock; or f rom the rest of the w o r l d ) . T h e reason is t ha t the use of the i n s t i t u t i ona l variable as a po l i cy ins t rument leads to externalit ies w i t h the same sign as the shock. I n these cases, cooperat ion w o u l d be undesirable because i t wou ld rein­force the effects of the disturbance when internal iz ing externali t ies.

For supply shocks, supply pol icy coordinat ion would be undesir­able when shocks have their o r ig in either w i t h i n the two countries of the monetary un ion simultaneously, or in the rest of the wor ld . B u t when the shock has its or ig in i n only one of the countries of the mon­etary union , cooperation would be desirable bu t only for the count ry where the shock appears. Note tha t , i n this case, cooperation w o u l d be also undesirable i n general termsj i n other words, cooperat ion wou ld not be Pareto-opt imal .

b) For the beggar-thy-neighbour effect, for a l l the shocks f rom the rest of the wor ld , as well as monetary shocks or ig ina t ing w i t h i n the union , externali t ies have the same sign as shocks. I n those cases, the cooperative solut ion requires a greater change i n the i n s t i t u t i ona l variable t h a n compet i t ive solut ion; thus, cooperation would be unde­sirable, since i t wou ld reinforce the effects of the shock when inter­nal iz ing externali t ies. I n t u r n , for supply shocks f rom the monetary un ion , we ob ta in the same result as i n the locomotive effect case: when the shock has its o r ig in i n only one of the countries of the monetary union , cooperat ion wou ld be desirable bu t only for the count ry where the shock appears.

O n the contrary, i n the case of real shocks from the monetary union , cooperat ion wou ld be desirable since externalit ies have the op­posite sign as the shocks. I n those cases, the cooperative solut ion requires a smaller change i n the in s t i t u t iona l variable t h a n compet i ­t ive solut ion.

To summarise, we can conclude tha t , i f the monetary union's au­thor i t ies include the budget deficit as an objective i n the i r loss func­t i o n , supply pol icy coordinat ion wou ld be desirable only when dealing w i t h real shocks or ig ina t ing w i t h i n the union, and when changes in the interest rate and the real exchange rate prevail as the channel of transmission. I n D í a z - R o l d á n (2000a), we can find the opposite results for fiscal pol icy coordinat ion, in tha t paper,, coordinat ion was

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found to be desirable only when monetary and supply shocks o r i g i ­nated w i t h i n i n the un ion , as wel l as for any k i n d of shock from the rest of the wor ld .

Summaris ing the results obtained so far, the condi t ions under wh ich coordinat ion of supply policies wou ld be desirable are shown in table 3.1. We can conclude tha t the results are determined not on ly by whether or not the shocks is country-specific, bu t also b y its na ture (monetary, real or supply-side), and the channel of t ransmission. I n the case of supply shocks, cooperation between the member countries of the union is always undesirable, bu t when dealing w i t h demand shocks, the channel of transmission proves to be determinant .

T a b l e 3 . 1. Desirability of Supply Policy Coordination

in a Monetary Union

Shock Cooperation

Monetary {m, m*) Undesirable

Real ( / i , / 2 , r ) • Locomotive effect: undesirable, • Beg gar-thy-neighbour effect: desirable, when the shock has its origin within the monetary union, and undesirable for the rest of the cases.

Supply (51,52,5*) Undesirable

4 . C o n c l u s i o n s

I n this paper we analyse how the member countries of a monetary un ion can deal w i t h shocks using coordinated supply-side policies, i n the absence of an independent monetary pol icy and w i t h restr ict ions i n the use of fiscal policy. I n order to offset the effects of the shocks, the authori t ies use as a pol icy ins t rument an i n s t i t u t i ona l variable wh ich could be interpreted as a way of harmoniz ing labour marke t ins t i tu t ions .

We have developed a three-country model i n wh ich two o f the countries fo rm a monetary union, and where a common independent central bank controls monetary policy. Next , we have used the Game Theory approach to analyse the authori t ies ' strategic behaviour w h e n deciding how to deal w i t h shocks.

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I n our model , supply shocks had unambiguous effects on o u t p u t and prices. O n the contrary, the effects of demand shocks depended on the prevai l ing channel o f transmission: when aggregate demand dominated , we had the locomotive effect, whereas i f changes i n the interest rate and the real exchange rate dominated , we had the beggar-thy-neighbour effect.

After analysing the solutions for the different cases, we concluded t ha t i n a monetary un ion w i t h some restrictions on fiscal policy, sup­p ly pol icy coord ina t ion wou ld be desirable only when the p robab i l i t y of suffering from real shocks or iginated w i t h i n the un ion is higher, and provideing tha t changes i n the interest rate and the real exchange rate prevai l as the channel of transmission. I n other words, coord ina t ion wou ld be desirable when facing shocks requi r ing a different po l icy response i n each country, i.e., asymmetric shocks.

L i n k i n g this conclusion w i t h tha t obtained by D í a z - R o l d á n (20 02), we can conclude tha t the "size" of the monetary union (smal l or large) is not relevant for the results. I n tha t art icle, supply-pol icy coord ina t ion was desirable only when dealing w i t h country-specific real shocks or iginated w i t h i n the small monetary union, and leading to different effects i n each country, i.e., when shocks lead to the beggar-thy-neighbour effect T h e same conclusion holds i n this paper (see table 3.1), since i n a large monetary union we add the shocks f rom the rest of the w o r l d , wh ich affect the monetary union i n a symmetr ic way. I n other words, the desirabi l i ty of supply-side in tervent ion i n a monetary union does not change when t ak ing in to account shocks f rom the rest of the w o r l d .

To conclude, the country-specific or ig in of the shocks w o u l d not be the on ly relevant characteristic i n deciding whether to coordinate economic policies: the nature (demand or supply) and the channel of transmission of the shocks wou ld be also relevant to determine the asymmetry of the shock. For this reason, i t wou ld be crucial to know wha t w o u l d be the channel of transmission and the k i n d of d is tur­bances actual ly prevai l ing i n a par t icular monetary union. Note tha t a l lowing for not- ful ly-ant ic ipated shocks wou ld lead to a stochastic version of the model . I n general, the results above wou ld hold even under this new assumption, though associated to the p robab i l i t y of occurrence of the shock.

A further extension to this paper migh t be to analyse the dy­namic impl ica t ions of flexible exchange rates. I n Bajo-Rubio and D í a z - R o l d á n (2003), the t r ad i t iona l Munde l l -F leming plus aggregate supply model is modif ied in several ways, inc lud ing a dynamic version of the model presented in this paper. I n the dynamic model , perfect

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capi ta l m o b i l i t y is defined i n terms of the uncovered interest par i ty , so t h a t interest rates are l inked th rough changes in the exchange rate. Regarding demand shocks, the results wou ld be equivalent to those obtained for the beggar-thy-neighbour effect i n the static version of this paper. O n the other hand, the results obtained for supply-side shocks show tha t the effects on prices wou ld be ambiguous. Therefore, the most remarkable impl i ca t ion of in t roduc ing dynamics seems t o be the reinforcement of the beggar-thy-neighbour effect, since d u r i n g the t rans i t ion dynamics, variat ions on the exchange rate lead t o changes i n the interest rate and so on. For tha t reason, the interest rate and the exchange rate wou ld tend t o dominate as channel of transmission.

R e f e r e n c e s

Bajo-Rubio, O. and C. Díaz-Roldán (2003). A dynamic analysis of monetary unions with an interest rate rule, Department of Economics, Universidad de Castilla-La Mancha (mimeo).

Bayoumi, T. and B. Eichengreen (1993). "Shocking aspects of European mon­etary integration", in F . Torres and F. Giavazzi (eds.), Adjustment and growth in the European Monetary Union, Cambridge, University Press, pp. 193-229.

Calmfors, L. and J . Driffill (1988). "Bargaining structure, corporatism and macroeconomic performance", Economic Policy, 6, pp. 13-61.

De Miguel, C. and S. Sosvilla (2001). "Efectos de políticas macroeconómicas en una unión monetaria con distintos grados de rigidez salarial", Hacienda Pública Española, 156, pp. 221-242.

Díaz-Roldán, C. (2002). On the desirability of supply-side intervention in a monetary union, WP E2002/21, Fundación Centro de Estudios Andaluces.

Díaz-Roldán, C. (2000a). Coordination of fiscal policies in a monetary union, WP 2000/03, Department of Economics, Universidad Pública de Navarra, Pamplona.

Díaz-Roldán, C. (2000b). Supply policies coordination in a monetary union, WP 2000/04, Department of Economics, Universidad Pública de Navarra, Pamplona.

Jimeno, J . F . (1992). "Las implicaciones macroeconómicas de la negociación colectiva: el caso español", Moneda y Crédito, 195, pp. 223-281.

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Sibert, A. C. and A. Sutherland (1997). Monetary regimes and labour mar­ket reform, Discussion Paper, 1731, Centre for Economic Policy Research, London.

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