A static framework for the Analysis of Policy Optimisation with Interdependent Economies

The idea of optimal policy design using an explicit loss function was a natural consequence of the development of econometric models of the macroeconomy. Since the economic theory underlying these was, at first the comparative static Keynesian model the techniques used tended to be static also. This approach can be seen in Tinbergen (1956). In addition since most of the early theory of open-economy macroeconomics was within the small open economy framework single controller models were felt adequate to capture the policy optimisation proble, facing a country. As models have come increasingly to concentrate on the dynamics of macroeconomic variables and the interdependence of economies has become more obvious it has become necessary to modify and extend our optimisation methods. The problem of dynamic models is easily dealt with using the standard techniques of optimal control theory i.e. dynamic programming or Pontryagin methods. The problem of interdependence can be handled by use of game theoretic concepts. We propose to set out the standard solution concepts of game theory in a static context because we feel this gives an intuition for the issues which it is difficult to obtain from the more technically demanding dynamic game literature. As an application we will consider throughout the problem of policy optimisation with interdependent economies.