Working Paper: CEPR ID: DP63
Authors: David Backus; John Driffill
Abstract: Dynamic inconsistency provides a theoretical basis for discussions of policy credibility: when the government cannot commit its future policies, the incentive to deviate from the 'optimal' plan renders it incredible. We derive the best policy in the absence of precommitment as the feedback Nash solution to a dynamic game between the government and a private sector composed of small agents. The solution is dynamically consistent by construction, and therefore credible. An application to disinflation shows that the feedback Nash policy may be considerably more costly than the 'optimal', but inconsistent policy. The analysis also reveals the source of the inconsistency of benevolent governments' policies.
Keywords: rational expectations; dynamic consistency; feedback solution; atomistic agents; disinflation
JEL Codes: 023; 214; 300
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Lack of government commitment (H11) | Credibility problem (E51) |
| Type of policy chosen (G52) | Economic outcomes during disinflation (E31) |
| Dynamic inconsistency (D80) | Loss of credibility (Z13) |