Interactions among Private Investors and Government Policies : Rules versus Discretion

Models fiscal policy interactions between fiscal authorities and private investors in the foreign exchange market in a game‐theoretic framework. Using a two‐period game, I consider the credible and noncredible announcements of the domestic fiscal authority with respect to the stance of its future fiscal policy. Each country faces a trade‐off between its current account and budget deficit objectives and time‐inconsistency arises due to lack of a sufficient number of policy instruments. For this game I derive explicitly the time consistent and precommitment policies for the domestic fiscal authority and explain that precommitment is welfare improving relative to the time‐consistent policy. In a two‐country framework, both precommitment with respect to the private sector and co‐operation between the two policymakers tend to improve welfare.