Gains from Policy Coordination

The previous section has illustrated how large countries typically face positive or negative spill over effects associated with aggregate demand policy. This causes economies to be mutually interdependent. In this context if each country sets its own monetary policy unilaterally then there is the possibility that the final outcome will be Pareto inefficient. This will occur when governments have more policy objectives than policy instruments. If government's have at least as many independent instruments as objectives then they can, if certain conditions are met, achieve all their objectives simultaneously. This is an application of Tinbergen's Theorem (1952) which states that for a government to achieve all of its independent policy objectives it must have at least as many independent policy instruments.