DP4941 Time Consistency of Fiscal and Monetary Policy: A Solution

Author(s): Torsten Persson , Mats Persson , Lars E O Svensson

Publication Date: March 2005

Keyword(s): time consistency , ramsey policy , surprise inflation

JEL(s): E31 , E52 , H21

Programme Areas: International Macroeconomics , Public Policy

Link to this Page: www.cepr.org/pubs/dps/DP4941.asp

This paper demonstrates how time consistency of the Ramsey policy (the optimal fiscal and monetary policy under commitment) can be achieved. Each government should leave its successor with a unique maturity structure for the nominal and indexed debt, such that the marginal benefit of a surprise inflation exactly balances the marginal cost. Unlike in earlier papers on the topic, the result holds for quite general Ramsey policies, including time-varying polices with positive inflation and positive nominal interest rates. We compare our results with those in Persson, Persson and Svensson (1987), Calvo and Obstfeld (1990), and Alvarez, Kehoe and Neumeyer (2004).