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Working Papers (1999), ESSEC Business School

Euroland versus USA: A Theoretical Framework for Monetary Strategies

Should the new European Central Bank take the euro-dollar exchange rate as an objective of its policy? And what would then be the consequences on the volatility of the euro-dollar exchange rate? In the light of these questions, the aim of this article is to study the various possible strategies of both the American and European policy makers. For that, we use a game theoretical approach, first with a finite horizon, second with an infinite one. Two strategies are possible ("hawk" and "dove"). Depending on the time horizon, the equilibrium solution leads to two main implications. First, in the finite horizon case, an optimal Pareto solution can only be attained if both players mutually agree not to disrupt each other's expectations on the exchange rate. Secondly, in the infinite horizon situation, it is in the interest of each player to address a clear and strong signal to the other about its own strategy. This result leads to some propositions as to the optimal strategy of the European Central Bank with respect to the Federal reserve system.

FOURÇANS, A. and WARIN, T. (1999). Euroland versus USA: A Theoretical Framework for Monetary Strategies. ESSEC Business School.