A race to the bottom? : a game-theoretic approach to monetary policy interdependence
MetadataShow full item record
- Master Thesis 
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.