Date Added: Feb 2011
This paper studies optimal monetary and fiscal policy in a small open economy. Two forces in the economy impose orthogonal restrictions on financing costs across governments. The first force requires constant financing costs across governments to have time consistent optimal policy of hours. The second force always asks for time varying financing costs across governments in order to have time consistency optimal policy of consumption and real money balances. Thus, optimal monetary and fiscal policy is time inconsistent. However, if preferences (and/or productivity) satisfy certain conditions, the former force disappears and optimal monetary and fiscal policy becomes time consistent.