Assume that the domestic government is interested in stimulating domestic output

(to get as close as possible to some given full employment target, y > 0) without, however, creating a large government sector (which could give rise to large deficits).

We assume that the domestic policy maker minimizes some cost function, LG:

LG (y — + 2g2, (11.55)

subject to the reduced form expression summarizing the domestic economy, given by the first expression in (11.54). In a similar fashion, the foreign policy maker has the loss function:

Lc = 2 (y* - p) 2 (s-12 (11.56)

that it minimizes subject to the constraint imposed by the reduced form expression for foreign output (the second equation in (11.54)). It is assumed that the domestic and foreign policy makers have the same output targets, i.e. y features in both

(11.55) and (11.56).