Board of Governors of the Federal Reserve System

January 1989

A New Interpretation of the Coordination Problem and its Empirical Significance

Matthew B. Canzoneri and Hali J. Edison

Abstract:

In this paper, we discuss a new interpretation of what might be meant by the "coordination" of policies; in this interpretation, the policymakers are selecting a noncooperative solution rather than a cooperative solution. The new interpretation is suggested by the fact that games typically have a large number of Nash solutions, and players are not indifferent as to which occurs. The multiplicity of solutions may be due to information sharing and surveillance, the choice of policy instruments, or the adoption of reputational strategies in repeated versions of the game. The "coordination" problem: results from policymakers' desire to coordinate on a good Nash equilibrium. In section I, we use the simulations of the MCM and the DECO model that were prepared for the May 1988 FRB Monetary Conference to derive reduced forms for inflation and output, and we simulate a one-shot game. We calculate an uncoordinated Nash solution, a Nash solution coordinated on the low deficit assumption, two more Nash solutions coordinated on instruments as well as the low deficit assumption, and finally a cooperative solution. By comparing them, we hope to assess the empirical relevance of the new interpretation of the coordination problem. The Nash solutions based on the low deficit assumptions are to be viewed as approximations to coordinated Nash solutions based on information sharing and surveillance, always overstating their case.

In section II, we provide new simulations from the MCM to illustrate the dynamic paths of four possible outcomes under coordination and to look for indicators. The simulations consider the two scenarios for U.S. government purchases--low and high. Given these two scenarios, two sets of possible responses are considered. The first set of responses correspond to when the policymakers are correct in predicting the path of the U.S. deficit. The second set of responses occur when the policymakers are wrong. The simulations show how much better off each country is when the policymakers get the shock right; they also suggest which indicator variables might be used as early warnings of mistaken assumptions.

In section III, we study a game that centers on instrument selection instead of information sharing and surveillance. Policymakers in the United States, Germany and Japan inherit inflation problems and full employment. We begin by calculating a Nash solution in which the United States is using the interest rate, while Japan and Germany are using money supply. Then we see how the outcome changes if the United States switches to the money supply or if the policymakers decide to cooperate.

We find, measuring importance by the percentage decrease in losses, that coordination on instruments is about ten times as important as cooperation, and we find that coordination on information and surveillance is about ten times as important as coordination on instruments. The results from our one-shot games are reinforced by the simulation exercise. Furthermore, the simulations suggest that interest rates or exchange rates would be good early warning indicators of mistaken assumptions about the size of the U.S. deficit; the current account would not, since it adjusts very slowly.

PDF: Full Paper