Is Optimal Monetary and Fiscal Policy in a Small Open Economy Time Consistent?

Liu, X (2010): Is Optimal Monetary and Fiscal Policy in a Small Open Economy Time Consistent?

Abstract

This paper studies optimal monetary and fiscal policy in a small open economy. Two forces in the economy impose orthogonal restrictions on financing costs across governments. The first force requires constant financing costs across governments to have time consistent optimal policy of hours. The second force always asks for time-varying financing costs across governments in order to have time consistency optimal policy of consumption and real money balances. Thus, optimal monetary and fiscal policy is time inconsistent. However, if preferences (and/or productivity) satisfy certain conditions, the former force disappears and optimal monetary and fiscal policy becomes time consistent. The results hold with both flexible exchange rate regimes and fixed exchange rate regimes. The latter indicates that a credible fixed exchange rate regime does not help render optimal policy time consistent.

• Item Type: MPRA Paper
• Language: English
• Keywords: Time consistency; Optimal monetary and fiscal policy; Small open economy.
• Subjects: E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E62 - Fiscal Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics; E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook > E61 - Policy Objectives ; Policy Designs and Consistency ; Policy Coordination

References

Albanesi, S., Chari, V. V., Christiano, L. J., 2003a. Expectation traps and monetary policy. Review of Economic Studies 70 (4), 715–741.

Albanesi, S., Chari, V. V., Christiano, L. J., 2003b. How severe is the time-inconsistency problem in monetary policy? Quarterly Review, 17–33.

Albanesi, S., Christiano, L. J., 2001. Comment on the costs of losing monetary independence: The case of mexico. Journal of Money, Credit and Banking 33 (2), 398–403.

Alvarez, F., Kehoe, P. J., Neumeyer, P. A., 2004. The time consistency of fiscal and monetary policies. Econometrica 72 (2), 541–567.

Backus, D. K., Driffill, J., 1985. Rational expectations and policy credibility following a change in regime. Review of Economic Studies 52, 211–221.

Bailey, M. J., 1956. The welfare cost of inflationary finance. Journal of Political Economy 64, 93–110.

Barro, R. J., Gordon, D. B., 1983. Rules, discretion and reputation in a model of monetary policy. Journal of Monetary Economics 12 (1), 101–121.

Calvo, G. A., 1978. On the time consistency of optimal policy in a monetary economy. Econometrica 46 (6), 1411–1428.

Calvo, G. A., Obstfeld, M., 1990. Time consistency of fiscal and monetary policy: A comment. Econometrica 58 (5), 1245–1247.

Chari, V. V., Christiano, L. J., Eichenbaum, M., 1998. Expectation traps and discretion. Journal of Economic Theory 81 (2), 462–492.

Chari, V. V., Christiano, L. J., Kehoe, P. J., 1991. Optimal fiscal and monetary policy: Some recent results. Journal of Money, Credit and Banking 23 (3), 519–39.

Kydland, F. E., Prescott, E. C., 1977. Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy 85, 473–490.

Lucas, R. J., Stokey, N. L., 1983. Optimal fiscal and monetary policy in an economy without capital. Journal of Monetary Economics 12 (1), 55–93.

Lucas, R. J., Stokey, N. L., 1987. Money and interest in a cash-in-advance economy. Econometrica 55 (3), 491–513.

Persson, M., Persson, T., Svensson, L. E. O., 1987. Time consistency of fiscal and monetary policy. Econometrica 55, 1419–1431.

Persson, M., Persson, T., Svensson, L. E. O., 1996. Debt, cash flow and inflation incentives: A swedish example. Tech. rep.

Persson, M., Persson, T., Svensson, L. E. O., 2006. Time consistency of fiscal and monetary policy: A solution. Econometrica 74 (1), 193–212.

Persson, T., Svensson, L. E. O., 1986. International borrowing and time-consistent fiscal policy. Scandinavian Journal of Economics 88 (1), 273–95.

Rogoff, K., 1985. The optimal degree of precommitment to an intermediate monetary target. Journal of International Economics 18, 1169–1190.

Schmitt-Groh´e, S., Uribe, M., 2003. Anticipated ramsey reforms and the uniform taxation principle: The role of international financial markets. Tech. rep.

Schmitt-Groh´e, S., Uribe, M., 2007. Optimal simple and implementable monetary and fiscal rules. Journal of Monetary Economics 54 (6), 1702–1725.

Svensson, L., 1997. Optimal inflation targets, conservative central bankers and linear inflation contracts. American Economic Review 87, 98–114.

Svensson, L. E. O., 1985. Money and asset prices in a cash-in-advance economy. Journal of Political Economy 93 (5), 919–44.

Tabellini, G., 1985. Accommodative monetary policy and central bank reputation. Giornali degli Economisti e Annali di Economia 44, 389–425.

Tinbergen, J., 1956. Economic Policy: Principles and Design. Amsterdam: North-Holland.

Tower, E., 1971. More on the welfare cost of inflationary finance. Journal of Money, Credit and Banking 3 (4), 850–60.

Uribe, M., 2006. A fiscal theory of sovereign risk. Journal of Monetary Economics 53, 1857–1875.