ABSTRACT

This paper illustrates the role for macroeconomic policy coordination when interdependent economies are pursuing disinflationary policies. Under flexible exchange rates, policy makers have an incentive to reduce inflation by pursuing contractionary policies that yield a currency appreciation. In a Nash, perfect foresight equilibrium, policy authorities in the model pursue contractionary policies to achieve currency appreciation, but these attempts cancel out, with the result that all countries end up pursuing excessively contractionary policies (relative to a symmetric Pareto optimum). The paper presents these results in a two—country, infinite—horizon difference game.

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