Time Consistency of Optimal Monetary and Fiscal Policy in a Small Open Economy

Abstract:     
This paper characterizes conditions under which optimal monetary and fiscal policy is time consistent in a stylized small open economy with a flexible foreign exchange rate regime. It shows that these conditions depend on the way in which leisure is assumed to enter preferences and/or on the process which productivity is assumed to follow. This paper further argues that these conditions may fail to be sufficient if the small open economy implements a fixed foreign exchange rate regime. Thus, a credible fixed exchange rate regime does not necessarily help render optimal policy time consistent.

Keywords: Time consistency, Optimal monetary and fiscal policy, Small open economy

JEL Classification: E52, E61, E62

working papers series