Federal Reserve Bank of Minneapolis Research Department Staff Report 98/JV

Coordination of Fiscal Policies in a World Economy Patrick J. Kehoe* Federal Reserve Bank of Minneapolis and University of Minnesota

ABSTRACT This paper provides a simple counterexample to the standard belief that in a world economy in which all countries are small, strategic interactions between policymakers are trivial and thus cooperative and noncooperative government policies coincide. It is well known that this holds for tariff policies. However, this paper demonstrates the result does not apply to government policies generally. Indeed, this paper presents a simple counterexample for the case of fiscal policy. In addition, the paper analyzes how optimally coordinated fiscal policies differ from noncooperative policies. It finds that, relative to optimally coordinated levels, noncooperative government spending can be too high or too low, depending on the sign of a transmission effect which captures the overall effect countries’ actions have on each other. *Andrew Abel, David Backus, Robert Hodrick, Paul Richardson, Thomas Sargent, and James Schmitz provided helpful comments. Edward Prescott provided valuable guidance at an early stage of this project. Kathy Rolfe provided useful editorial assistance. This project was undertaken in connection with Sloan Foundation Grant 85-4-3, called “Coordination of Macroeconomic Policies in Dynamic Open Economies.” The views expressed herein are those of the author and not necessarily those of the Sloan Foundation, the Federal Reserve Bank of Minneapolis, or the Federal Reserve System.