FISCAL-POLICY WHEN MONETARY-POLICY IS TIED TO THE MAST

This paper analyses the time inconsistency problem of both exchange ra te and fiscal policy in a small open economy. The equilibrium under di scretion is characterised by inflation and a deficit. Commitment of th e exchange-rate instrument only, e.g. through membership in a European monetary union with low inflation, contributes to price stability but may increase the deficit. Whether the government will prefer this out come to the discretionary one will depend on the structure of the econ omy. We conclude that the time-inconsistency argument strengthens the case for simultaneous commitment of monetary and fiscal policy for inf lation-prone countries joining a monetary union.