Optimal Monetary Policy and the Asset Market: A Non-cooperative Game

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 three different noncooperative games: Nash equilibrium, Stackelberg equilibrium with “FED” as leader and “ECB” Stacklberg as leader. Three major conclusions can be drawn from our work in the presence of asset market shocks. First, in the Nash equilibrium the ECB will adopt a less restrictive monetary policy compared to the FED’s behaviour. Second, comparing the Nash and Stackelberg non-cooperative equilibria, the Stackelberg solution is certainly superior when the FED is the leader, but the Nash solution is superior for the follower. Finally, irrespective of where the shocks originate, if the FED would choose the Stackelberg leader equilibrium the ECB would minimize its social loss along with a lower level of interest rates.