Monetary and Fiscal Policy in a “Small” Exchange Rate Union a Strategic Analysis

In this chapter a model describing the strategic interactions between two countries forming an exchange rate union will be developed. The two countries are supposed to be subjected to exogenous disturbances coming from the rest of the world and pursue their targets using policy instruments, the change of which also affects the other member’s targets. The system of interdependence is derived from chapter IPs model, i. e. a modified version of the two-country Mundell-Fleming model as adapted to the exchange rate union case with the introduction of the third component “rest of the world” by means of exogenous variables. In particular, the medium-run version of the model will be used, as the most idoneous for the purpose of analysing policy interactions. This distinguishes the system of interdependence from the two-country ones used in the already existing literature, as, for instance, in Niehans (1968), Hamada (1974, 1976), Corden (1978).