Optimal Monetary Policy and Asset Market Shocks Under Cooperative and Non-cooperative Games

Abstract In this paper we construct a model of a policy game in order to analyse the optimal reaction function of the Central Bank to a shock in the asset market. In doing so, we consider a cooperative game and three different non-cooperative games: Nash equilibrium, Stackelberg equilibria (with two large economies, e.g. country “a” and “c”, with an accommodate and conservative central bank respectively and different games in which we assume that both central banks react to a shock in their asset markets. Three major conclusions can be drawn from our work in the presence of asset market shocks. First, in a cooperative and non-cooperative game framework, the optimal monetary policy assuming that the central bank considers the information from the asset market. In particular, we examined the impact of shocks in the asset markets and Phillips curve on domestic and foreign monetary policy. For the simulation we used true data for two big countries, USA and Europe. In our view the monetary authorities of these two countries can better represent the “conservative” and the “accommodate” central bank assumed in the model where, of course, the first is associated with the European Central Bank (ECB) and the second with the Federal Reserve (FED). The results from the impulse response functions show that, following an unexpected increase of the US asset market, the patterns of the output responses are similar in both countries that is, a positive shock in the USA stock market increases output gaps. Different responses are obtained when we consider the effects on the inflation in the two countries. Despite the fact that the patterns are similar, the magnitude of the impact is slightly different. Moreover, following an unexpected increase of the European stock market, the patterns of the output responses are dissimilar in the two countries that is, a positive shock in the EU stock market increases output gap in the USA while, for the first six months it has a negative impact on the EU output gap. Different responses are also obtained when we consider the effects on the inflation in the two countries. Finally, we found that, under a cooperative game, the FED minimise its loss functions in all the four potential shocks we examined. Different is the situation for the ECB where, it minimises its loss function with tighter monetary policy only in the cooperative scenario with a shock in the EU stock market and when it acts as follower in the Stackelberg game with a Phillips curve shock.