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Time Consistency of Monetary Policy in the Open Economy (Revised: 8-90)

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  • Henning Bohn

Abstract

The paper is concerned with time-consistency problems caused by monetary policy in an open economy. The temptation to generate surplus inflation is shown to depend positively on the amounts of nominal debt issued by the government or issued by individuals. Private debt matters, because inflationary money growth causes redistribution between domestic residents and foreigners. A government that cares about welfare of its residents will be tempted to inflate whenever it or its residents have issued nominal debt to foreigners. A net creditor position, however, may eliminate the time-consistency problem. If money supply affects real exchange rates, foreign currency debt has similar incentive effects as nominal debt, but typically in the opposite direction. The time-consistency problem may be reduced or even eliminated by issuing foreign currency debt. To maximize the incentive effect, this debt should be sold to foreigners. Hence, international portfolio diversification may reduce welfare. For the United States, these international considerations should become increasingly relevant as the country accumulates external deficits. My estimates indicate that the incentive to inflate more than doubled between 1982 and 1987. More than two-thirds of this increase was due to higher external debt, which was largely financed in nominal terms.

Suggested Citation

  • Henning Bohn, "undated". "Time Consistency of Monetary Policy in the Open Economy (Revised: 8-90)," Rodney L. White Center for Financial Research Working Papers 33-88, Wharton School Rodney L. White Center for Financial Research.
  • Handle: RePEc:fth:pennfi:33-88
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    Cited by:

    1. Maurice Obstfeld, 1990. "The Effectiveness of Foreign-Exchange Intervention: Recent Experience, 1985- 1988," NBER Chapters,in: International Policy Coordination and Exchange Rate Fluctuations, pages 197-246 National Bureau of Economic Research, Inc.
    2. Maurice Obstfeld, 1988. "The Effectiveness of Foreign-Exchange Intervention: Recent Experience," NBER Working Papers 2796, National Bureau of Economic Research, Inc.

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