Public Policy and Economic Growth in an Imperfectly Competitive World of Interdependent Economies

We consider an artificial world of two interdependent economies which produce differentiated commodities and accumulate human capital. Commodities are traded and human capital production depends on country-specific public expenditures and world-wide knowledge. Public goods are differentiated in terms of their relative yields of consumption and production services. The terms of trade link between countries gives rise to negative policy spillover effects on welfare whilst the externalities in human capital production account for positive policy spillover effects on welfare. We study optimal policy as the equilibrium outcome of a dynamic game between benevolent governments. We show that, whilst welfare is never lower, growth may either be higher or lower under cooperation than under non-cooperation depending on the extent to which public goods are differentiated and the relative strenghts of different cross-country externalities.