The case for a symmetric reaction function of the European Central Bank

Donatella Gatti and Christa van Wijnbergen

No FS I 99-305, Discussion Papers, Research Unit: Economic Change and Employment from WZB Berlin Social Science Center

Abstract: In a macro-economic framework where the European Central Bank targets individual country data, the nature of strategic interactions between fiscal authorities in the euro-zone can be described as a stag hunt game with (at least) two equilibria that can be pareto-ranked. In fact we show that, because of the indiscriminate nature of its monetary response, an ECB strategy of monetary retaliation to any individual country's over-expenditure affects all eleven countries to the same extent. This collective effect is similar to the teacher's old favorite "all children stay behind in the class if one misbehaves". This mechanism, we show, makes the game between fiscal authorities a multiple equilibria co-ordination game. We subsequently address the problem of equilibrium selection that is of particular importance to co-ordination games. Following Kandori et al. (1993), we apply Harsanyi and Selten's (1988) riskdominance criterion to single out the conditions for fiscal restraint to emerge as the equilibrium selected by interacting actors. Our main conclusions are that the ECB can ensure convergence of fiscal authorities upon the pareto-optimal equilibrium (that is, fiscal restraint) by adopting a reward-oriented, counter-cyclical strategy that compensates fiscal authorities at the output level both for giving up fiscal discretion and for incurring the risk of being hit by a monetary tightening in response to developments elsewhere in the euro-economy. This means that interest rates' movements should smoothen economic fluctuations in order to give economic actors sufficient incentives to maintain restraint.

Date: 1999
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Related works:
Working Paper: The Case for a Symmetric Reaction. Function of the European Central Bank (2005)
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