The Time Consistency of Monetary and Fiscal Policies

Are optimal monetary and fiscal policies time consistent in a monetary economy? Yes, but if and only if under commitment the Friedman rule of setting nominal interest rates to zero is optimal. This result is of applied interest because the Friedman rule is optimal for the standard preferences used in applied work, those consistent with the growth facts. ∗Alvarez, University of Chicago, Universidad T. Di Tella, and NBER; Kehoe, Federal Reserve Bank of Minneapolis, University of Minnesota, and NBER; Pablo Neumeyer, Universidad T. Di Tella and CONICET. Alvarez and Neumeyer thank Agencia de Promoción Científica y Tecnológica for financial support. Kehoe thanks the NSF for financial support. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. A classic issue in macroeconomics is whether or not optimal monetary and fiscal policies are time consistent. In a monetary economy, Calvo (1978) shows that the incentive for the government to inflate away its nominal liabilities leads to a time consistency problem for optimal policies. (See also Auernheimer 1974.) In a real economy, Lucas and Stokey (1983) show that the incentive for the government to devalue its real debt typically also leads to a time consistency problem for optimal policies. Lucas and Stokey (1983) have shown that, with a carefully chosen maturity structure for real government debt, optimal policies can be made time consistent in a real economy. But they have argued that the analogous result does not hold for a monetary economy with real and nominal debt. Here we show that it does. For a class of monetary economies typically used in applied work, we show that optimal policies are time consistent, but if and only if under commitment the Friedman rule of setting the nominal interest rate to zero is optimal. The model we use is an infinite horizon model with money in the utility function of the representative consumer. In this model, the government has access to nominal and real debt of all maturities and must finance a given stream of government expenditures with a combination of consumption taxes and seigniorage. Following Lucas and Stokey (1983), we abstract from the well-understood problems arising from capital taxation by not including any kind of capital. Our approach to the issue of time consistency is basically that of Lucas and Stokey (1983). To establish our benchmark for optimal policy, we begin by solving for Ramsey policies, namely, the optimal policies in an environment where the initial government has a commitment technology that binds the actions of future governments. In this environment, therefore, the initial government chooses policy once and for all. Ramsey policies here consist of sequences of consumption taxes and money supplies. We then turn to the environment of interest in which no such commitment technology exists. In it each government inherits a maturity structure of nominal and real debt. Each such government then decides on the current setting for the consumption tax and the money supply, as well as the maturity structure of nominal and real debt that its successor will inherit. We ask whether a maturity structure of government debt can be chosen so that all governments carry out the Ramsey policies. If it can, we call the Ramsey policies time consistent. It turns out that if the Ramsey policies are to be time consistent, then the structure of the nominal bonds that a government in period t leaves to its successor in period t+1 must be severely restricted. One of these restrictions is well understood: the present value of nominal claims must be zero. If this present value is positive, then the successor in period t+1 will inflate the nominal claims away by setting the price level in period t+1 to be very large, while if the present value is negative, the successor will make its claims on the public large by setting the price level in period t+ 1 to be very low. A critical step in our analysis is uncovering some more subtle restrictions: if the Friedman rule does not hold in some period t, then the present value of nominal bonds from that period on must be zero. This restriction on nominal bonds restricts the initial government’s means of influencing the choices of its successor to, primarily, real bonds. In general, the government in any period is so restricted in influencing its successor that it cannot induce its successor to carry out the continuation of its plan. In particular, if the Friedman rule does not hold, then no matter what structure the government sets for real bonds in period t, the successor government has an incentive to deviate from the continuation of the period t allocations either by altering taxes in a way that devalues the real debt or by changing the amount of seigniorage raised. When the Friedman rule holds, consumers are satiated with money balances and no seignorage is raised–as if money has disappeared–so that the economy is equivalent to a real economy. In this economy, the government in any period can induce its successor to carry out its plan by carefully choosing a maturity structure of the real bonds and by choosing the maturity structure of nominal bonds so that the value of nominal liabilities is zero in each period. We argue that economies for which the Friedman rule is optimal and hence those for which optimal policies are time consistent are both of applied interest. This is because the preferences most frequently used in the applied literature are those consistent with the growth facts, and we show that the Friedman rule is optimal for essentially all such preferences. We develop a useful analogy between our monetary economy and a real economy similar to