Time consistency of optimal monetary and fiscal policy in a small open economy

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.