For many economic models in the normative tradition of intertemporal fiscal policy analysis, the `Ramsey rule' which requires that marginal tax distortions be smoothed over time can be supported through intricate asset-management schemes that remove the incentive for time-inconsistent actions even when the government is unable to pre-commit. For others, `reputational' equilibria in which expectations incorporate a trigger-strategy punishment mechanism can do the job. Equilibria in which Ramsey allocations are not in general attained may arise, however, because the asset-management strategies that ensure time consistency place extreme informational demands on governments which can not survive even minor changes of economic assumptions. Furthermore, there is as yet no convincing account of how economic actors might coordinate on the precise expectations supporting any particular reputational equilibrium.

In Discussion Paper No. 431, Research Fellow Maurice Obstfeld shows how a government that cannot make credible policy commitments might manage its exchange rate and fiscal stance in a world of rational expectations. This model may generate diverse patterns of dynamic behaviour. Depending on the assumptions made concerning the government's objectives, the continuing strategic interaction between the public and private sectors may lead to a disinflationary outcome or to a spiral of rising debt and inflation.

Obstfeld's model departs from those in the Ramsey tradition in two key respects. First, it takes account of the time- inconsistency problem that can arise when the government cannot pre-commit by focusing on equilibria in which the government manages its deficit strategically with an eye towards market expectations of currency depreciation. Second, it allows for the possibility that government objectives may not correspond to those of the representative domestic household, and this latter modification allows it to encompass, at least in a descriptive way, some effects of political uncertainty.

Obstfeld argues that the reduction of public debt may act as a government `investment' that lowers the incentive to inflate and thus lowers market expectations of inflation to the benefit of private welfare and the public finances. When the government's discount rate is the same as the market interest rate, this public-good aspect of debt reduction leads to a gradual fall in inflation over time. In the case of myopic government, however, the expectational effects of debt reduction may clash with other incentives favouring rising inflation, thus implying a debt- inflation spiral and an inflationary long-run position for the economy.

A Model of Currency Depreciation and the Debt-Inflation Spiral
Maurice Obstfeld