We model the intertemporal tradeoff between fiscal and monetary policy under inflation targeting. An indebted policymaker chooses public expenditure and inflation. Private agents form expected inflation. The debt level determines target credibility. For an endogenous interval of debt, the fiscal fragility zone (FFZ), there are multiple equilibria, expected inflation is above the announced target, and debt rollover is expensive. Within the FFZ, policymakers should (i) employ fiscal austerity to gradually reduce debt and (ii) increase the inflation target to raise the lower bound of the FFZ. The optimal inflation target is the lowest target whereby the economy exits the FFZ.

In a traditional open macro model, we show that when we account for the common exchange rate puzzles, we also generate general equilibrium levels for international reserves and exchange rate volatility consistent with common emerging markets values. In such an environment, the country finds it optimal to issue debt in domestic currency to finance assets in foreign currency. In a model without such correction, we show that the optimal portfolio on foreign currency consists of a short position, e.g. a debt in foreign currency. This correction is done through a financial friction and key calibration.
We show this result using both a reduced form and a micro foundation for the financial friction. To outline the intuition, all results are obtained with closed-form solutions.