How Useful is Game Theory in Monetary Economics?

I get an interesting question from an ee432 student today, who asked about the application of game theory to monetary economics, or to any real-life problems for that matter. Given that I have more than a few things to say, I hope you don't mind me posting the answer up instead of replying to you privately.

The first thought that comes to my mind is a remark by one of my past teachers, that "Economics is really game theory". Of course it's no surprise that he IS a game theorist, but I can certainly relate to that view. Economics for the most part is really a study of how clever people get on with their lives in a tough world. And when you pitch more than 2 clever people to interact with each other, you have a game. It's no surprise then that game theoretical way of thinking has penetrated almost all fields in economics, in various disguises. And applications are not restricted to economics... biologists, diplomats, sociologists have all used the tool to a good measure of success.

Monetary economics is no exception. If you can recall, right from our first topic on the use of fiat money as a medium of exchange, we did employ the notion of Nash equilibrium, the good old concept in game theory. In that world, people are playing the game of 'let's coordinate our choice of money so that we can trade faster', and the result is that even an intrinsically worthless piece of paper can be regarded as money in Nash equilibrium...fiat money is born!

Or when we do rational expectations (either in Lucas or New Keynesian models), we are basically looking at agents who are strategically very smart and are reacting to any changes in aggregate demand pattern in a rational way. If you just add in another smart guy who's controlling the aggregate demand and reacting strategically to the public (a central bank!), then again you have a game! We will precisely do this in topic 6, the science of monetary policy. You will see then that the monetary policy in modern days is essentially a game between a mister Ben Bernanke and the public.

Or in our class tomorrow, when I will continue discussing the Diamond-Dybvig model of bank runs, you'll see that we use the Nash equilibrium concept again to describe the outcome under banking allocations. Whether or not there is a bank runs, it depends on your confidence of the bank. But your confidence depends on others confidence, so it's a strategic decision, and hence calls for a game theory as a framework. Or when we move on to topic 5, on time inconsistency, again we will look at a game played by the policy maker and the public. Game theory appears almost everywhere once you look closely.

And I can say that modern economic research in monetary economics has not had enough with game theory...in fact, it wants more! Examples of recent works which I like are by Susan Athey on the optimal degree of monetary policy discretion, Hyun Song Shin on the benefit/cost of policy transparency (social value of public info), Markus Brunnermeier on asset price bubbles formation for example. These works are probably too advanced for an undergrad project, but just to show you that the application is really endless. The challenge is really to master the skills and techniques, which may take time and patience. But I do believe the reward will be worth your while.

Also check out http://www.gametheory.net/ to get more ideas.