Macroeconomic Policies in a Monetary Union: A Dynamic Game 1 Reinhard Neck, Doris Behrens Department of Economics, University of Klagenfurt, Universitaetsstrasse 65- 67, A-9020 Klagenfurt, Austria, Tel. +43 463 2700 4121, Fax +43 463 2700 4191, Email: reinhard.neck@uni-klu.ac.at, doris.behrens@uni-klu.ac.at Summary: We develop a dynamic game model of a two-country monetary union to study strategic interactions between macroeconomic policy-makers facing adaptive inflationary expectations. In this union, governments of participating countries pursue national goals when deciding about fiscal policies, whereas the common central bank’s monetary policy aims at union-wide objectives. For a symmetric demand shock, we derive numerical solutions of the dynamic game between the governments and the central bank, using the OPTGAME algorithm (Behrens and Neck, 2003a). Different solution concepts for this game serve as models of a conflict between national and supra-national institutions (non-cooperative Nash equilibrium) on the one hand and of coordinated policy-making (coopera- tive Pareto solutions) on the other. We show that the volatility of output and inflation increase when actual inflation reacts more strongly to expected inflation. Moreover, there is a trade-off between instruments’ and targets’ de- viations from desired paths. Keywords: dynamic game; numerical solutions; Nash equilibrium; Pareto solution; economics; fiscal policy; monetary policy; monetary union. 1. Introduction In the theory of quantitative economic policy, macroeconomic policy-making has usually been regarded as an optimum control problem according to a single 1 This research was financially supported by the Jubiläumsfonds of the Austrian Na- tional Bank (project no. 9152). An earlier version was presented at the 8th Viennese Workshop on Optimal Control, Dynamic Games and Nonlinear Dynamics: Theory and Applications in Economics and OR/MS, Vienna, May 14–16, 2003. Thanks are due to two anonymous referees for helpful comments. The usual disclaimer applies.