Working Paper: CEPR ID: DP227
Authors: Paul Levine
Abstract: The paper addresses the Kydland and Prescott (1977) argument that the optimal policy in models with rational expectations is time-inconsistent. This, it is argued, undermines the credibility of the optimal policy in the eyes of the private sector, who will expect the policy-maker to reoptimize. Therefore policy, if it is to be credible, must be constrained to be time-consistent. For many models, this is a serious constraint. Barro and Gordon offer a different approach to the time inconsistency problem. They assume that policy-makers suffer a loss of reputation if they renege on earlier commitments. With this "punishment" mechanism in place, Barro and Gordon show that there exist policies superior to the time-consistent policy which are credible and sustainable. The Barro-Gordon analysis is, however, model-specific and, in particular, applies only to static models. The main purpose of this paper is to show how their analysis can be generalized to any rational expectations model with structural dynamics and stochastic exogenous shocks.
Keywords: time inconsistency; reputation; credibility; rational expectations
JEL Codes: 023; 026; 321
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| time inconsistency of optimal policies (D15) | undermines credibility (D83) |
| lack of reputation for precommitment (D82) | incentive to deviate from ideal policy (D72) |
| incentive to deviate from ideal policy (D72) | Nash noncooperative equilibrium characterized by nonzero inflation (C72) |
| introducing a punishment mechanism (D47) | restore credibility to the ideal policy (E61) |
| punishment mechanism (K40) | sustainable ideal policy (Q01) |
| balance between temptation to renege and enforced costs of losing reputation (Z13) | sustainability of the ideal policy (Q01) |
| long punishment interval and high discount factor (D15) | ideal policy can be made credible (D78) |