A race to the bottom? : a game-theoretic approach to monetary policy interdependence
Abstract
The recent low interest regime of most central banks in the world raises several questions.
First, it appears that the interest rates may have been too low during periods of recessions.
Second, the key policy rates seem to stay low even after signals of improved economic
conditions. Considering this, we question whether monetary policy truly considers the optimal
development of the domestic economy? Or are interdependencies between different central
banks limiting the freedom for domestic optimal monetary policies? This thesis aim to
highlight how monetary policy interdependencies and inflation targeting can be better
understood using game theoretic intuition.
Our point of departure is a static New Keynesian framework for optimal monetary policy.
Then, we illustrate how an economy mainly considering its domestic economy will react to
foreign interest rates. By extending the framework to allow for interdependencies, we illustrate
how Nash-behavior drive two central banks to respond more aggressively to each other’s
interest rate. This results in a “race to the bottom” in the key policy rate levels when the
economies are hit by an adverse economic shock. Further, we argue that certain mechanisms
might contribute to a prisoner’s dilemma hindering key policy rates to return to “normal”
levels after an economic shock. We also derive a theoretical cooperative interest rate
equilibrium between the two central banks. Here we illustrate how the central banks can
facilitate each other’s monetary policy and thus reduce the aggregate loss of both economies.
To shed empirical light on these mechanisms, we then compare the key policy rate of nine
inflation targeting economies to the Taylor rate. Our analysis find some evidence of key policy
rates being systematically below the Taylor rate during and after the Dotcom bubble recession.
During and after the Financial crisis recession, there are stronger evidence for key policy rates
deviating significantly from the Taylor rate. This, suggest that the interest rate levels were too
low. At last we find some evidence of a negatively sloped trend in the key policy rates
compared to the Taylor rate. This, we argue, might indicate that the monetary policy strategy
has become more aggressive over time. If this is true, it calls for a revision of how inflation
targeting is carried out, incorporating game theoretic intuition. Further, the discussion
concerning global monetary policy coordination might also have to be revised.