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

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.