International policy coordination in interdependent monetary economies
A classical equilibrium model is analysed of two interdependent monetary economies in which it is assumed that cash is the only asset, and which is characterized by perfect foresight, flexible exchange rates and imperfect substitution between home and foreign goods. The first-best optimum sets the marginal rate of substitution between private and public goods to unity and leads to no tax distortions and the optimal quantity of money. Both non-cooperative and cooperative market-oriented outcomes are time-inconsistent, since each government has an incentive to renege and levy a surprise inflation tax. International policy coordination without precommitment can be counterproductive even though there are no tax distortions and the provision of public goods is optimal, since it exacerbates the credibility problems perceived by the private sectors and therefore leads to excessive inflation and too low a level of real money balances. The reason is that a unilateral surprise inflation tax induces a real depreciation and leads to inflation costs, but a multilateral expansion of monetary growth does not. The typical ranking in order of decreasing welfare is first-best optimum, cooperation with precommitment, competition with precommitment, competition without precommitment and coordination without precommitment.
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