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

This paper shows that optimal fiscal and monetary policy is generally time consistent in a standard small open economy. Further, there exist many maturity structures of public debt capable of rendering the optimal policy time consistent. This result is in sharp contrast with that obtained by others in the context of closedeconomy models. In the closed economy, the time consistency of optimal monetary and fiscal policy imposes severe restrictions on public debt in the form of a unique term structure of public debt that governments at each point in time can leave to their successors. In addition, this paper shows that the time consistent result is robust in the sense when not all real and nominal bonds over infinite horizon are available, optimal policy can still be time consistent. While in the closed economy, governments must have both real and nominal bonds over infinite horizon to render optimal policy time consistent.