X. Liu, 2013, Time Consistency of Optimal Monetary and Fiscal Policy in a Small Open Economy, Journal of International Money and Finance, 45(6), 1117-1146. [Link]
Fiscal Impossible Trinity in a small open economy:
In a small open economy with only conventional debt instruments, it is impossible to have three things to hold at the same time, capital mobility, fixed exchange rates, and time consistency of optimal fiscal policy.
This paper bridges two major strands of modern macroeconomics: the time-consistency literature initiated by Kydland and Prescott and the open-economy policy analysis pioneered by Mundell. It shows that the Persson, Persson, and Svensson commitment mechanism capable of supporting time-consistent optimal fiscal policy in a closed economy breaks down in a small open economy with fixed exchange rates and free capital mobility. The resulting impossibility trilemma implies that these economies cannot simultaneously achieve fixed exchange rates, capital mobility, and the time consistency of optimal fiscal policy. As such, the paper may be interpreted both as an open-economy version of the Kydland-Prescott impossibility result and as a fiscal analogue of Mundell's policy trilemma.
Time consistency has been a central issue in the analysis of monetary and fiscal policy. Time inconsistency has been widely regarded as the main reason for many problems.
To restore time consistency, a lot of commitment technology has been proposed. The most recent technology is the (appropriately chosen) maturity structure of public debt. Persson, Persson, and Svensson (2006) showed that an appropriate maturity structure of public debt is capable of rendering optimal monetary and fiscal policy time consistent in a closed economy.
Put it differently, in this closed economy, the government has sufficient policy instruments (nominal and real bonds of different maturities) to influence policy choices of the next government in such a way that optimal (monetary and fiscal) policy can be rendered time consistent.
Even though a real bond of a certain maturity time can be treated as a policy instrument in a closed economy, it is not the case in a small open economy. This is because the government cannot influence real interest rates. In other words, what really matters is not the maturity structure but rather the discounted sum of real bonds.
In a small open economy with flexible exchange rates and issuing only conventional nominal and real bonds:
Without imposing additional restrictions, the commitment technology (the appropriately chosen maturity structure of nominal and real bonds) in Persson, Persson, and Svensson (2006) is not sufficient any more. In other words, optimal monetary and fiscal policy in this small open economy is time inconsistent.
However, when additional conditions are satisfied, the commitment technology in Persson, Persson, and Svensson (2006) may render optimal monetary and fiscal policy time consistent.
The additional conditions are related with preferences and productivity.
In a small open economy with a fixed exchange rate and issuing only conventional nominal and real bonds:
In this case, the monetary economy effectively reduces to a real economy.
The commitment technology and these conditions fail to be sufficient again.
Mathematically, I show that there exist orthogonal restrictions:
both labor and money markets ask for constant marginal financing costs;
while the goods market asks for time-varying marginal financing costs.
Intuitively, the current government does not have enough policy instruments to influence the policy choices of the next government. As a result, optimal fiscal policy is time consistent.
Thus, I obtain my impossible trinity:
In a small open economy with only conventional debt instruments, it is impossible to have three things to hold at the same time, capital mobility, fixed exchange rate, and time consistency of optimal fiscal policy.
In a small open economy with a fixed exchange rate and issuing not only nominal and real bonds but also innovative debt instruments:
The commitment technology and these conditions may be sufficient again
The orthogonality may be removed with the innovative debt instruments.
M. Persson, T. Persson, and L. Svensson, (2006) Time Consistency of Fiscal and Monetary Policy: A Solution. Econometrica 74 (1), 193–212.