Topic 5. Policy Coordination Problems


In this last Topic in the series of lessons we pull things together and look at world monetary policy from a broader point of view. We have been concentrating almost entirely on a situation where the world consists of one big country and a large number of small ones. It was demonstrated that, apart from situations where a small country wants to change its actual and expected inflation rate, that country will find it in its interest to keep markets orderly and thereby follow the monetary policy of the big country. If the big country is following a stable monetary policy, the small country can gain little by acting independently.

In the industrialized world, however, we have more than one big country. The Euro Area represents a currency area, and therefore a country for our analytical purposes, almost as big as the United States. And at some point, China and India will certainly also enter the picture. How does world monetary policy work when there are two big countries (or currency areas) and many small ones?

If there are two big countries following different short-run monetary policies, the exchange rate of their currencies will have a tendency to vary substantially as a result of monetary factors in addition to the whole range of real factors likely to affect it. If one of the two countries cares about this exchange rate and maintains an orderly foreign exchange market by continually supplying a quantity of base money sufficient to eliminate overshooting, that country will end up following roughly the same monetary policy as the other big country which, we assume, does not care about exchange rate movements. If both countries are anxious to avoid overshooting nominal exchange rate movements, they could end up working somewhat at cross-purposes, thereby providing an opportunity for huge profits at their expense for private speculators. It would seem that the primary tool of policy coordination should be the telephone! The authorities of the two countries or currency areas will have to work together!

If the policies of the big countries are coordinated, small countries that manage to maintain an orderly market for their exchange rate with either big-country currency will also end up following a stable monetary policy roughly equivalent to the similar monetary policies of the two big currency areas. If the monetary authorities of the big countries cannot agree about how to deal with current business cycle fluctuations and operate using different short-run monetary policies, each small country has to chose which of the two exchange rates to maintain an orderly relationship of their domestic currency with, and therefore which of the two big countries' monetary policies to indirectly follow.

When big countries screw up big-time, as discussed in the previous Topic Past Mistakes Big and Small, other countries which maintain orderly markets will, as there demonstrated, tend to follow the same policies and the world economy will descend into crisis. Under those circumstances there will be enormous political pressures within countries to "do something". To proceed independently and maintain some appearance of order, countries can adopt fixed exchange rates at levels that provide favorably low real exchange rates to shift world demand onto their output. They can impose tariffs to channel domestic demand onto domestic output and attempt to control capital movements to prevent domestic savings from being channeled abroad into foreign investment. Indeed, competitive devaluations and "beggar-thy-neighbor" tariff policies were a major feature of the Great Depression of the 1930s. When the rest of the world becomes unstable, there is an understandable tendency to "circle the wagons" and try to go it alone! Obviously, the world is worse off as a result of those policies!

On this sad note we could have a final test. Any appropriate questions, however, would simply be a review of what has been studied in this and earlier Lessons. It would probably be better for you to spend the time reviewing that earlier material and going over the questions asked in earlier tests.

Choose Another Topic in the Lesson.