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It is interesting that in modern times such as these when our central banks speak with such calm authority of the virtue of their decisions that we can have intelligent debate about the nature of policy interaction that might question some of their decisions or at least their timing. My own sense is that our bank always will act last because F is relatively well known.
P.S. That you for indicating the source of your article. I will explore further there.

Jci: "My own sense is that our bank always will act last because F is relatively well known."

That is my sense too. But it's not totally obvious. You could think of monetary and fiscal authorities as taking turns to move in a never-ending repeated game, rather than moving just once like in my one-shot game here. And it depends on what each has promised about how long it will maintain its current choice, or whether each is free to move again whenever it feels like it.

Nick: It never occurred to me that fairies played a role in IO. However, maybe I was implicitly biased towards accepting them, having spent several years as a monetary economist convinced that money was like pixie dust.

So Linda: do you think the stereotype of IO types is correct?

Yep, it sounds strange to hear the difference between Cournot and Bertrand as being due to "fairies". "Those aren't magical fairies; they are just the little people who are all around us and define the strategy space, which we take for granted." It's all just "expectations".


You mention that re: Bertrand or Cournot competition it matters what the actual firms believe about the strategy space.

Observably, firms (or the people who run them) actually do have models in their head about what will happen if they do X. Business schools teach class after class on it. Many firms have employees whose only job is to think about that strategy space.

Just as observably, Congress has no coherent model. Most of the individual members don't really have any model at all for what the Fed does, and the rest disagree with each other! Treating them as an optimizer seems clearly wrong, even as the roughest of approximations. You can't even treat them as optimizing their chances of reelection, because different parts of Congress are actually enemies!

Finally, if Congress ever perceived that the Fed really was playing this sort of game with them, they would probably be furious and immediately amend its charter to force it to stop sabotaging them.

These aren't fairies, these are choices and behaviours.

Is the question different if a country has parliamentary government where the budget, as proposed by the Minister of Finance, is substantially what will be enacted because the continued life of the current parliament clearly depends on passing a budget?

In Canada, the UK, Australia, France, Germany and most other countries, the Minister of Finance is clearly responsible for fiscal policy and has the backing of his party to enact that policy. Thus fiscal policy in parliamentary countries is far, far more coherent than in the US.

Very interesting post.

Is it fair to say that denying central banks "goal independence" is done specifically to avoid playing this game entirely, or at least to always reach your (3) equilibrium? At least in countries where the central bank is a subordinate of the fiscal authority, and the central bank's nominal target derives from the same Treasury which sets fiscal policy. I just read this Charlie Bean paper where he talks all this from the BoE perspective, with specific mention of (3).

And doesn't flexible IT hence somewhat undermine the cause of goal independence? Because flexible IT involves discretion over the weighting of inflation and the "output gap", and the CB's judgement of the gap and the weighting are neither directly observable nor (necessarily) disclosed or agreed between CB and fiscal authority. The central bank's next choice again becomes unknown to the fiscal authority, even if the judgements in the last choice are known.

Alex: "Observably, firms (or the people who run them) actually do have models in their head about what will happen if they do X"

What matters here is what model they hold in their heads about what the other firms are doing. "Are the other firms choosing a price, or a level of output?"

Determinant: "These aren't fairies, these are choices and behaviours."

My choices include: how many bank shares to own, and how much to hold in my chequing account. Those two variables are part of my strategy space. That strategy space would be incoherent for someone living 2,000 years ago.

200 years ago (is my history correct?) how many slaves to own would have been part of my strategy space. Today that strategy space is incoherent.

We don't think the same way as we used to about the set of things we can do, and that others can do. What makes conceptual sense has changed.

The history of civilisation is the history of changes in the strategy space, which change the equilibrium of how we interact with each other.

Must do a post on this.

Britmouse: Thanks!

"Is it fair to say that denying central banks "goal independence" is done specifically to avoid playing this game entirely, or at least to always reach your (3) equilibrium?"

Hmm. I can see how governments telling central banks they have to target 2% inflation (which is what the govt wants, rather than the 0% target central bank wants) would solve the problem. Good point.

"And doesn't flexible IT hence somewhat undermine the cause of goal independence?"

Hmm. Yes.

Good post - I'm wondering if the lack of comments simply indicates that what you're saying is so sensible that no one could possibly disagree with it? Perhaps people are away on holiday.

Another excellent post. One reason you have this problem is that the fiscal and monetary authority don't realize they are playing the same game. Especially the fiscal authority. The government thinks it's targeting real growth with fiscal policy, and it thinks the central bank is targeting inflation.

Alex says the Congress would be furious if they understood the Fed was sabotaging fiscal policy. That's probably true, but what's so amusing is that Congress INSTRUCTED THE FED to sabotage fiscal policy--when they gave the Fed the dual mandate.

I'm sure you know what I'm going to say next. If both the government and the central bank thought in terms of NGDP targets, the game would immediately become transparent, and budget deficits might well become smaller (I agree with you that many fiscal authorities (wrongly) believe they are playing game one.)

Frances: you know game theory. Your thesis had a lot of game theory. You were taught by Ken Binmore, IIRC? The intersection of game theory and monetary policy is a narrow one. Most readers' eyes are probably glazing over. I should have titled it: "A mathematical proof of the existence of fairies". Then people would think what I am saying is so silly they couldn't possibly agree with it. And I would get lots of comments.

Thanks Scott! Hmmm. I am assuming common knowledge of the Aggregate Demand function. Yes, I think your point about people thinking that fiscal policy affects Y and monetary policy affects P probably has a lot of truth in it. "After all, it's obvious when you look at Y=C+I+G+NX and P=MV/Y"

Continuing after Scott, what if one doesn't even realize it is playing the game? What if the other is deciding both ngdp and the deficit wanting neither larger but is faced with either one or both larger? We will have just as large a deficit as the Fed wants.

If values, institutions, laws and other social choices are "fairies", so be it, but if I bounce a cheque there are real consequences, and I don't have to run the risk of losing my total earthly wealth by getting mugged because it's all in the bank.

Maybe I'm being too practical. D**m Engineering degree.

This expectations matter on steroids: I like it.

I think a more realistic model is one where each side has a herd of cats. The conference room has different doors each standing for a strategy. You meet once a month and have thirty minutes to herd your cats through the door of your choice using only verbal encouragement.

Now you have two considerations monetary strategy and feline strategy. If you have the more well behaved cats, the likelihood is that you'll get to choose first, or, if you want to move second, you'll be able to do so without the risk lack of lack of feline consensus.

Without a consensus, the result is defined to be keep on doing nothing concrete. You can, of course, drop hints about the superior quality of your cats, which enables you to act in a timely manner when the need arises, which need has not yet arisen, but your cats stand ready.

As the source of monetary policy, you get to meet in a boardroom. The fiscal side meets in Grand Central Station at rush hour. Sometimes this encourages the cats to move quickly, but it makes it hard to control their direction. Particularly as any number of interfering bystanders are calling "here, kitty, kitty" and brandishing cat treats.

The point, of course, is that a strategy has to persuade as well as work. You have to persuade your side to adopt it and the public to believe in it. Some policies are popular and persuasive. Others are not.

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