Working Paper: CEPR ID: DP536
Authors: Daniel Cohen; Philippe Michel
Abstract: The dynamic inconsistency of a government's preferred policy, when it occurs, usually implies that the maximum level of welfare that can be delivered at some initial time can only be attained by constraining the economy to `low' levels in the future. In this paper, we set up a linear quadratic model in which the `best' policy rule which is looked for today is subject to the constraint of always delivering in the future a given reservation level of welfare which in equilibrium is the level that the `best' policy itself offers to deliver. We fully characterize the solutions to this problem in the cases when the government policies are constant, linear and kinked linear.
Keywords: credibility; macroeconomic policy; time inconsistency
JEL Codes: 130310
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government Policy (G1) (F68) | Initial Welfare (W1) (I38) |
| Initial Welfare (W1) (I38) | Future Constraints (C1) (D10) |
| Future Constraints (C1) (D10) | Future Welfare (W2) (I38) |
| Initial Policy Effectiveness (E1) (D78) | Time Passage (T) (C41) |
| Time Passage (T) (C41) | Decreased Effectiveness (E2) (I24) |
| Chosen Policy Rule (P) (D78) | Reservation Welfare Level (W_res) (I38) |
| Simple Rules (SR) (C73) | Political Credibility (PC) (D72) |
| Political Credibility (PC) (D72) | Welfare Outcomes (W_out) (I38) |