Book reviews 185

aspects, and including a good bibliography. It will therefore till an important market niche that Helpman and Krugman (1985) did not fill. The book could have been substantially improved, particularly in the theory sections, but on the whole I am glad it was written. I expect it to be widely read.

James A. Brander University of British Columbia

Koichi Hamada, The Political Economy of International Monetary Indepen- dence (MIT Press, Cambridge, MA, 1986) pp. ix+ 187, f22.50.

Professor Hamada’s book represents a comprehensive survey of his work on international monetary interdependence, a field in which he was ‘one of the key originators’, as the publisher rightly notes. The novelty of his analysis stems from a systematic game-theoretic approach to the study of the international monetary system. In Hamada’s words, an international mone- tary system can be viewed as the outcome of a two-stage game. During the first stage, the nations choose which system they want to adhere to (fixed or flexible exchange rates). During the second stage, they follow the rules of the game selected at the first node and the outcome depends upon which Nash equilibrium is realized. Hamada begins by analyzing the first stage, which he compares to the ‘battle of the sexes’ game, then turns to the second stage, which he compares to the ‘prisoner’s dilemma’. Yet, the opposite order of exposition may have been more appropriate. As is now standard in the search for sub-game perfect equilibria, one would rather solve this two-stage game ‘backwards’. First, one should consider what are the outcomes of a fixed and a flexible exchange rate system, then decide which system should be selected at the outset. In this review, I shall organize my discussion in this latter manner.

A fixed exchange rate system is an agreement by a collection of nations to undertake to maintain a fixed parity between their currencies. Each Central Bank accumulates reserves so as to defend the parity of its currency. If a nation is too small to influence the world money supply, it will take the world inflation rate as given. With one instrument (its own money supply), it will undertake to attain two targets: the level of reserves which the Central Bank finds it desirable to accumulate, and the level of output which its monetary policy can help the country to achieve. Yet, in a fixed exchange rate system, a small country cannot modify the quantity of money circulating domestically. Any change in the money supply of the Central Bank is immediately offset by a change in its reserves. Therefore, even though there may be a ‘true’ Phillips curve operating in the economy, each (small) Central

CM Book rmiews

Bank wih only set its supply of money to the level which is consistent with its desired level of -es. When all countries attempt to do so (non- cooperatively), the world is driven to a point on the inflatio-utput locus that only depends upon the preferences of the various CentraI Banks about their levels of reserves. When ah Central Banks want to accmnuIate more reserves, the equilibrium will be characterized by a deflationary bias: each Centrai Bank wiIl reduce its money supply so as to accumulate reserves, and by all doing so, they will contract the world economy.

When the nations of the world are not so small, so that they each recognize their influence on the world money supply, the Central Banks will internalize some of the influence of their actions on world inflation Yet, this recognition will only be partial and the world inflation will be like a public good: you may want some of it, but it is your hope that mainly your neighbor wilI produce it. As a result, too little of the good w-ill be produced And again the world economy will exhibit a contractionary bias-

To avoid this problem, MundeU has suggested that all but one of the countries should care about their reserves, while the last would care only about the world innation- Since (n - 1) policies are snfficient to deal with the n balance of payment problems, this is surely a workable proposal. which amounts to giving the nth country the role of the leader in the n player game If the folfowers do not like the leader’s preferred inflation, however, the system need not improve their welfares (while it necessarily improves the leader’s pay-off).

In a floating exchange rate system, each Central Bank is free to determine the amount of money circulating domestically. Furthermore, in a ‘pure float’ the Cenfral Bank does not wish to arrumulate reserves- Again, the Central Bank has one instnunent (its money supply) and two goals: a rate of inflation and an output target Yet, this system is not free from spill-over e&c&. With each point on the inflation-output locus is implicitly associated an equilibrium real exchange rate. For instance, a contractionary monetary policy appreciates the real exchange rate (and reduces both inflation and ootput). In a non-cooperative floating exchange rate system, these spill-over effects are not taken into account by the Central Bank (or only partially so) and the equilibrium is Pareto inefhcient. For instance, when all the nations of the world simuhaneonsly decide to reduce their domestic inflation, they will impose upon themselves a counterproductive contractionary bias, each nation try&g to appreciate its currency against its neighbor-3~ This is the analog, under a floating exchange rate, to the contractionary bias obtained in a fixed exchange rate system when all Central Banks attempt to augment their resemesm

There is no straightforward counterpart to the Mundell proposal (to let one country disregard its balance of payments and stabilize world inflation). Here, none of the Central Banks care about their balance of payments and the rrth equation problem does not arise.

Having roughly described these two systems along the lines spelled out by Hamada, we may turn now to the initial question: Which system is more likely to he adopted? To narrow the scope of the analysis, one may think of the following two sub-questions. (a) In a fixed exchange rate regime, are there incentives for a single nation to kt its currmcy floss in other words, is there a free-rider problem? (b) In a floating exchange rate regime, what cost- benefit analysis may induce a country to peg its currency to anothds, or induce countries to form a monetary union? Given the order of exposition of his book (which analyzes the choice of a monetary regime hefore telling us where this choice leads the economy to), Hamada provides no direct answer to these questions, but only indirect ones. To the first sub-question, a simple answer is that a free-rider nation is one that is not satisfied with the world rate of inflation When each country is small and plays noncooperatively, this outcome may arise due to the inefficiency of the non-cooperative equikiirium. When the Mundeil proposal is applied, this may be due to a divergence between the nth country’s preferred inflation and that of the other countries-

On the other sub-question (when to form a monetary union}, Hamada ofks the following conclusion: ‘Unless the European Countries move toward political integratios monetary integration will be difficult to achieve.’ This is because the short-run cost of any union, the loss of the monetary policy instrument, is immediate, while the bene6t.s come only in the long run, after conlidence has been built that the monetary union wiII not breafr do= Indeed, the useful historical references given in the book show that ‘poKcal integration invariably preceded compIete monetary integration’.

Nobody can really disagree with this view, but I do not think that it is substantiated enough- On the one hand, the loss of the monetary policy instrument is valid for each country individually, but not for the union as a whole. The ECU, for example, is not like gold (whose supply is exogenous to Central Banks) and there may very well be an active European monetary policy. The true problem comes about due to possiile divergences between the countries’ prefiiences- But these divergences provide a useful way to compare the performance of a monetary union to a fixed or a flexible exchange rate system. Indeed, we saw that a contractionary bias arises when alI countries want simultaneously to inaease their reserves or to appreciate their currencies, ie. precisely when they have the same preferences If one fears that the cm-rent exchange rate system has a contractionary bias, one must then also be optimistic about the prospects for snccess of a monetary union.

Daniel Cohen CEP-