Monetary Policy Co-ordination in an Asymmetrical World: Future Prospects for the USA and Europe

The formulation of economic policy in the USA, Japan and Europe (led by West Germany) in the first half of the 1980s can best be characterised as a non-co-operative policy game. Following the second sharp increase in oil prices in 1979–80 (OPEC-II) the US responded with a combination of easy fiscal and tight monetary policy. Fiscal policy was supposed to protect jobs and therefore minimise the deflationary effects of the oil price rise, while monetary policy was aimed at keeping inflation down by minimising the inflationary consequences of the increase in the price of oil. The success of the policy depended to a large extent on the ability of the Fed to cause a dollar appreciation, thereby exporting US inflation to the rest of the world. Europe, and to a lesser extent Japan, responded to the US policy mix by following tight fiscal and tight monetary policy. This was largely due to the strong German anti-inflationary bias in policy formulation and the disillusion in other European countries with the success of more accommodative policies in view of the experience of OPEC-I. The 1980s, in particular the first half of the decade, were characterised by very high nominal and real interest rates in the world, an unprecedented appreciation of the dollar, very high levels of unemployment in Europe, and the creation of the huge current account and budget deficits (the ‘twin deficit’) in the USA.