Regional integration in Latin America and dynamic gains from macroeconomic cooperation
Hubert Escaith and Igor Paunovic
The objective of this paper is to present and illustrate from a game-theory perspective, the main concepts and challenges behind macroeconomic policy cooperation in Latin America and the Caribbean. Examples are taken from fiscal, monetary and exchange rate policies in a regional framework. Translating these concepts and examples into the economics of sub-regional integration, when countries have increasing commercial and financial relations, interact frequently and cannot escape from the consequences their decisions have on their partners, the paper contend that entering into a cooperative dynamic will be beneficial for all cooperative participants. Moreover, it is shown that because the welfare gains from regional cooperation are endogenous, cooperation will eventually become stable, even in the presence of a Prisoner's Dilemma.
The concepts of static games are initially introduced to identify some of the costs and benefits of regional macroeconomic coordination. The arguments are developed using the example of tax and subsidy policies and the competition to attract foreign investment. Then, the document incorporates the dynamic aspects of cooperation, in particular the notion of time consistency. A review of the costs and benefits of regional coordination of macroeconomic policies is presented, from a dynamic point of view. The notion of endogenously determined criteria to form an optimal currency area is then introduced. We demonstrate that even when initial conditions are less than optimal, macroeconomic policy coordination within sub-regional integration schemes can lead to a stable cooperative situation. Nevertheless, at the initial stage of coordination, the benefits are uncertain and cooperation is unstable; consequently a formal institutional setting is necessary to start and coordinate the cooperative process, at least in its earlier stage.