Liquidity Constraints, Maturity Structure and Time-Consistency of Fiscal Policy*

Abstract

Both the maturity structure and liquidity constraints are important to have time-consistent optimal fiscal policy. The maturity structure of the initial bond holding position introduces asymmetry/symmetry in treating consumption goods across time, leading to time-inconsistent/consistent optimal fiscal policy. In a closed economy, Ramsey governments can treat all consumption goods symmetrically and the liquidity constraints are satisfied. Therefore, the optimal fiscal policy is time-consistent. In a small open economy, liquidity constraints result in an endogenous determinacy restriction from the labour market. This determinacy restriction on Lagrange multipliers is in general orthogonal to the restriction from the good market, leading to time-inconsistent optimal fiscal policy.