Question

Below is a game matrix representing game a played between Congress, which is responsible for fiscal policy (taxes and government expenditures), and the Federal Reserve (FED), which is in charge of monetary policy (primarily, interest rates) Federal Reserve Low interest Highintere:st Highta 3,4 Low tax 1,3 2,2 Congress (a) What is the Nash Equilibrium of this game? (b) Is there a dominant strategy for any of the playens? If so, what are they? (c) Is the Nash Equilibrium outcome socially desirable? Is there a different outcome where the society would be better off than in the case of Nash Equilibrium? If so, what is it? (d) Suggest a solution on how the players can cooperate and achieve the socially desirable outcome

Answer 1

A) When the Fed sets a low interest rate, Congress sets a low tax (4 vs 3). When the Fed sets a high interest rate, Congress sets a low tax (2 vs 1). This implies that Congress will always set a low tax rate. Given this, the Fed is better off with a high interest rate. Thus, the NE is (2, 2) where Congress sets a low tax rate and Fed sets a high rate of interest

B) Congress has a dominant strategy of setting a low tax rate. This is because it always selects low tax irrespective of what the Fed does. However, Fed follows the Congress so it does not have a dominant strategy

C) No. This is because socially desirable outcome maximizes joint payoff. Here the joint payoff is maximum when Congress sets a high tax and the Fed sets a low rate of interest. The joint payoff is now greater (3 + 4 = 7 is greater than 2 + 2 = 4)

D) Fed can announce that if the Congress is setting a low tax, it would set a high interest rate. This would discourage Congress to set a low tax because then its payoff will be 2 instead of 3 which is the one received under coordination.