Introduction

This book studies the strategic policy interactions in a monetary union. Here the focus is on the Nash equilibrium. The monetary union consists of two countries, say Germany and France. The policy makers are the European central bank, the German government, and the French government. An increase in European money supply lowers unemployment in Germany and France. On the other hand, it raises inflation there. However, it has no effect on structural deficits. An increase in German government purchases lowers unemployment in Germany. On the other hand, it raises inflation there. And what is more, is raises the structural deficit. Correspondingly, an increase in French government purchases lowers unemployment in France. On the other hand, it raises inflation there. And what is more, is raises the structural deficit. The targets of the European central bank are zero inflation in Germany and France. The instrument of the European central bank is European money supply. There are two targets but only one instrument, so what is needed is a loss function. We assume that the European central bank has a quadratic loss function. The amount of loss depends on inflation in Germany and France. The European central bank sets European money supply so as to minimize its loss. The first-order condition for a minimum loss gives the reaction function of the European central bank. Suppose the German government raises German government purchases. Then, as a response, the European central bank lowers European money supply.