Nash equilibrium: How it works in macroeconomics

The Nash equilibrium is a central concept in non-cooperative game theory, named after American mathematician John Nash. It represents a strategic state where no participant can improve their outcome by independently changing their decision, assuming all other players keep their strategies unchanged. In other words, each player’s choice is the most ideal response ot the choices of others, and any deviation would make them worse off.¹

The relevance of the Nash equilibrium in macroeconomics lies in its ability to model environments where strategic interdependence is prevalent.² In the global economy, key players (such as governments, central banks, and major institutions) often make decisions that depend on what others will do. Nash equilibrium offers a clear framework for understanding these interactions: it is the point where no one can improve their position by acting alone, as long as others stay the course.

To better understand how the Nash equilibrium applies in macroeconomics, it’s helpful to break the idea into a few key elements:

Strategic interaction

Macroeconomic environments are shaped by strategic interdependence, which means each decision depends on the expected actions of others.

For example, when a central bank considers adjusting interest rates, it must account for potential reactions from other central banks, as shifts in capital flows, exchange rates, and inflation expectations are all interconnected. Similarly, governments may coordinate or adjust their fiscal strategies in response to international policy changes, seeking stability in trade balances and economic growth.³

Best response

A strategy is the best response if it yields the highest payoff given the strategies chosen by others. In macroeconomics, this could involve a central bank setting optimal interest rates, considering the likely moves of other central banks or fiscal authorities.⁴

For instance, consider two central banks deciding whether to raise or hold their interest rates. Each bank’s optimal decision depends on anticipating the other’s likely action, since interest rate changes impact different elements. If both banks choose strategies that best respond to each other (such as both holding rates steady), neither would gain by shifting unilaterally.

No regrets

Nash equilibrium is often described as a ‘no regrets’ outcome. This means, once all decisions are made, no player wishes they had acted differently, given what others have done.⁵ This concept is particularly relevant when considering global coordination challenges.⁶

To illustrate, countries may compete by lowering corporate tax rates or hesitate to lead on climate action. Each focuses on its own short-term benefit, even though collective action would produce better global outcomes. In a Nash equilibrium, each country settles on a strategy it does not regret based on the actions of others, even if the overall outcome may not be the most efficient or collectively optimal.

Stability

A Nash equilibrium is considered stable when a small deviation by one player doesn’t unlock significant gains, nor prompt others to shift their strategies. This stability matters for policymakers, as it creates predictable environments where minor misalignments are unlikely to disrupt the broader system. As a result, stable equilibria help maintain confidence in coordinated policy even amid minor mistakes.⁷

A case in point is when two central banks align on a modest interest rate increase, neither benefits from lowering theirs in response, because doing so risks triggering capital outflows or inflationary pressures. That mutual reassurance builds stability into the coordination framework, giving decision-makers confidence in pursuing gradual policy adjustments.

Multiple equilibria

In some macro settings, multiple Nash equilibria can coexist, which means the economy may settle in very different outcomes based solely on collective expectations. This multiplicity amplifies systemic risks, as small shifts in sentiment or coordination can tip the system into a markedly suboptimal state.⁸

Currency crises often illustrate multiple equilibria. When investors trust that a central bank can defend its exchange rate, the currency tends to remain stable. But if confidence weakens, investors may sell the currency, triggering the collapse they feared. Both stability and collapse are possible, depending on investor expectations. 

The Prisoner’s Dilemma is a well-known game theory scenario that helps illustrate how the Nash equilibrium works in situations where self-interest conflicts with mutual benefit. This dilemma is illustrated by two individuals who are separated and must choose whether to cooperate (stay silent) or defect (betray the other. If both cooperate, they each get a modest penalty. However, if both choose to defect, they receive a harsher punishment.⁹

Because each fears the other will defect to avoid the worst-case scenario, the logical, yet collectively suboptimal outcome is that both defect, even though they would receive a better result by cooperating. This outcome reflects the Nash equilibrium, where no one can improve their situation by unilaterally changing their choice once the other has made theirs.

However, this example extends beyond a theoretical exercise. It demonstrates how individuals or countries may pursue strategies that align with their own interests, even when broader cooperation could produce more favorable outcomes for all parties involved. Similar dynamics can be seen in macroeconomic situations such as trade agreements or climate discussions, where participants may prefer to wait for others to act first.

For instance, countries might be cautious about reducing carbon emissions unless they observe similar commitments elsewhere, as there may be concerns about maintaining competitiveness. This can result in delayed action, even though coordinated efforts would likely lead to more beneficial global outcomes.

The Nash equilibrium provides a valuable framework for understanding strategic decision-making in macroeconomics. It helps explain how rational players, including governments, central banks, or large firms, make choices while considering how others might respond.

While the Nash equilibrium often identifies stable outcomes, these outcomes are not always the most collectively beneficial. This is evident in examples like the Prisoner’s Dilemma and in various policy coordination scenarios. Recognising the potential for multiple equilibria, understanding the distinction between Nash equilibrium and dominant strategies, and considering the possibility of less-than-optimal results are important for economic analysis and effective policymaking.

As the global economy becomes more interconnected and complex, the ability to apply Nash equilibrium effectively remains important for anticipating and shaping collective outcomes.

For more information about how Nash equilibrium works in macroeconomics, you will get engaging discussions, strategic insights, and real-world perspectives on policy coordination, global trade dynamics, and decision-making in an interconnected economy.

References

¹ Kenton W. Nash Equilibrium. Investopedia [Internet]. 2023 Apr 21 [cited 2025 Jun 19]. Available from:https://www.investopedia.com/terms/n/nash-equilibrium.asp

² MASEconomics. Exploring Game Theory and Strategic Behavior in Economics [Internet]. MASEconomics; 2023 [cited 2025 Jun 19]. Available from:https://maseconomics.com/exploring-game-theory-and-strategic-behavior-in-economics/

³ Ferrari Minesso M, Pagliari MS. DSGE Nash: solving Nash games in macro models. ECB Working Paper No 2678. Frankfurt: European Central Bank; June 2022. Available from:
https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2678~d03bdde9c8.en.pdf (cited 2025 Jun 23).

⁴ Davis J. Game Theory and the Nash Equilibrium. Investopedia. Published 29 April 2008.https://www.investopedia.com/articles/financial-theory/09/game-theory-beyond-basics.asp. Accessed 23 June 2025

⁵ CORE Econ. Strategic interactions: Modelling climate change [Internet]. CORE Econ; [cited 2025 Jun 19]. Available from:https://www.core-econ.org/the-economy/microeconomics/04-strategic-interactions-14-modelling-climate-change.html

⁶ Balvers R, Lee Y-C, Tiu C. Financial Crises as a Phenomenon of Multiple Equilibria and How to Avoid Them. University of San Diego, Digital Commons: Business Faculty; [year unavailable]. Available from:https://digital.sandiego.edu/cgi/viewcontent.cgi?article=1022&context=busnfaculty (cited 23 June 2025)

⁷ Carmona G, Podczeck K. On the existence of pure-strategy equilibria in large games [Internet]. Lisboa: Universidade Nova de Lisboa; 2008 [cited 2009 May 21]. Available from:
https://web.archive.org/web/20090521220332/http://fesrvsd.fe.unl.pt/WPFEUNL/WP2008/wp531.pdf

⁸ Cavallari L, Corsetti G. Shadow rates and multiple equilibria in the theory of currency crises [Internet]. J Int Econ. 2000 Aug;51(2):275–86 [cited 2025 Jun 30]. Available from:
https://www.sciencedirect.com/science/article/pii/S0022199699000306?utm_source=chatgpt.com

⁹ Vaia. Prisoner’s Dilemma: Definition & Example. Vaia; [cited 23 Jun 2025]. Available from:https://www.vaia.com/en-us/explanations/microeconomics/imperfect-competition/prisoners-dilemma/