Japanese researchers model success and failure of international cooperation

It is possible to model a situation where central banks cooperate on a globally optimal monetary policy, research published today (August 17) by the Bank of Japan finds.

Cooperation between central banks is often seen as desirable, because monetary policy can prove a ‘beggar-thy-neighbour' policy by triggering currency depreciation. The difficulty is, cooperation generally requires a country to subjugate its own interests to those of the global economy, at least partially.

The paper's authors, from Keio University, Tokyo University and the Australian National University, note that much of the existing research into global cooperation either assumes away cooperation problems, or focuses on showing how central banks can improve welfare given an uncooperative equilibrium.

Ippei Fujiwara, Timothy Kam and Takeki Sunakawa mark out a third way: what they call a "sustainable cooperation regime". In their model, central banks might have an incentive to cheat, but the incentive can be overcome by careful design of the cooperation agreement.

They proceed on the basis of a two-country open economy framework, characterised by firms acting under monopolistic competition. They introduce asymmetric mark-up shocks, which cause the country to deviate from its most efficient equilibrium.

The incentive problem becomes worse as the volatility of mark-up shocks rises, they find. The further a country finds itself from its domestic equilibrium, the more incentive there is for it to focus on the domestic economy, rather than setting the policy that maximises global welfare.

The size of a country also matters. When countries are different in size, the smaller country has a greater incentive to "walk away from the cooperative solution", and the outcome does impact on the larger country's welfare.

Key to maintaining the cooperative agreement is the combination of higher welfare than under the non-cooperative equilibrium, and an incentive offered to those that are more likely to walk away from the table. Large countries must compensate smaller ones, and those facing less volatile shocks must compensate those facing higher volatility.

"Countries in such a programme are willing to tolerate welfare redistributions whenever asymmetric shocks hit them, in return for better-than-non-cooperation outcomes," the authors say.

The authors stress it is not always possible to achieve the sustainable equilibrium – there may be times when the differences between two countries are too great. But they suggest their result conforms with some "real world" episodes, when central banks have cooperated, at least to some extent.

They cite remarks by Fed chair Janet Yellen and economist John Lipsky, who have both highlighted how central banks have cooperated post-2008. Yellen referred to "working closely" with international counterparts to avoid a race to the bottom, via forums such as the Bank for International Settlements.