NON-C O OPERATIVE EQUILIBRIUM S OLUTIONS FOR A STOCHASTIC DYNAMIC GAME OF ECONOMIC STABILIZATION POLICIES Reinhard Neck Institut fiir Volkswirtschaftstheorie und -poIitik~ Wirtschaftsuniversit/it Wien~ Augasse 2-6~ A-1090 Wien 1 Introduction During the sixties and seventies, optimal control theory has been the dominant paradigm for the formM analysis of macroeconomic stabilization policies. With the emergence of the new classical macroeconomics, however, this approach has increasingly been criticized. More recently, it became clear to theorists of stabilization policies that these and related critiques of the optimal control approach to the theory of economic policy call for the use of dynamic game instead of optimal control methods in the analysis of stabilization policies (el., e.g., Blackburn 1987). The use of dynamic game theory is not confined to problems where private-sector agents have rational expectations, but it ca~, also be applied if there are ditferent policy-makers exerting influence on the economy. In the present paper, we consider a policy conflict between two policy-makers for a closed economy. We investigate non-cooperative equilibrium solutions for a simple dynamic macroeconomic model subjcct to control by both the government and the central bank. The model is described in Section 2; its deterministic version can be reduced to an ordinary linear first-order differential equation. We assume that the dynamics is disturbed by an additive stochastic error term. Policy-makers have quadratic intertemporal objective functions. In Sections 3 and 4, respectively, we derive the feedback Nash and the feedback Stackelberg equilibrium solution to the re.suiting differential game. Due to the stochastic nature of the game, these are the appropriate equilibrium solutions under a symmetric and an asymmetric information pattern, respectively. Some remarks on the properties of these solutions and on their relations to other equilibrium solution concepts for the corresponding deterministic differential game ave given in Section 5. 2 The Model First, we consider a deterministic version of the dynamic economic model. It is based on an expectations-augmented Phillips curve with adaptive expectation8 and is designed to express the intertemporal trade-off between unemployment and inflation and the policy alternatives of stabiliza- tion policies. The rate of inflation p(t) depends on aggregate excess demand in goods and labor markets h(t) and on the expected rate of inflation p*(t):