Econometrica: Jan, 2006, Volume 74, Issue 1
Time Consistency of Fiscal and Monetary Policy: A Solution
Mats Persson, Torsten Persson, Lars E. O. Svensson
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 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).