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Time Consistency of Fiscal and Monetary Policy

Mats Persson
Torsten Persson
Lars E. O. Svensson

Abstract

The problem of time inconsistency arises from two different sources. First, as shown by Calvo (1978), there is an incentive for each government to engage in an initial unanticipated inflation. Second, as discussed by Lucas and Stokey (1983), there is an incentive for each government to deviate from the path of taxes announced by the preceding government. In this paper it is shown that these two sources of time inconsistency can be removed by a particular method of debt management, involving both nominal and indexed government bonds of various maturities.