Staff Report 305

The Time Consistency of Monetary and Fiscal Policies

Patrick J. Kehoe | Stanford University, University College London, Federal Reserve Bank of Minneapolis
Fernando Alvarez | Consultant
Pablo Neumeyer

Revised April 1, 2003

We show that optimal monetary and fiscal policies are time consistent for a class of economies often used in applied work, economies appealing because they are consistent with the growth facts. We establish our results in two steps. We first show that for this class of economies, the Friedman rule of setting nominal interest rates to zero is optimal under commitment. We then show that optimal policies are time consistent if the Friedman rule is optimal. For our benchmark economy in which the time consistency problem is most severe, the converse also holds: if optimal policies are time consistent, then the Friedman rule is optimal.

Published In: Econometrica (Vol. 72, No. 2, March 2004, pp. 541-567)

Download Paper (pdf)

Old Staff Report with Detailed Appendices (pdf)