Working Paper: CEPR ID: DP94
Authors: David Currie; Paul Levine
Abstract: This paper re-examines the issue of the credibility and sustainability of optimal policies derived from Pontryagin's Maximum Principle and generally regarded as time-inconsistent, in models with forward-looking rational expectations. Specifically, it considers the behaviour of such models in the presence of continuing stochastic noise. This is shown to convert the policy problem from a one-shot dynamic policy game to a continuing game, giving governments an incentive to invest in a reputation for not reneging on the full optimal rule. This incentive may, in certain circumstances, render the full optimal rule credible and therefore sustainable. It is demonstrated that a sufficiently low degree of discounting on the part of government, or a sufficiently high variance of shocks (measured relative to the initial displacement) ensures the sustainability of the full optimal rule. Using a simple dynamic open economy model, these conditions are shown to be plausible unless the discount rate is very high.
Keywords: optimal policy; time inconsistency; credibility; sustainability of policy
JEL Codes: 131; 133; 310; 320
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Stochastic noise (C69) | Change from one-shot game to continuing game (C73) |
| Change from one-shot game to continuing game (C73) | Incentive for governments to invest in reputation (H54) |
| Incentive for governments to invest in reputation (H54) | Credibility and sustainability of full optimal rule (E61) |
| Government's discount rate not too high OR High variance of shocks (E43) | Sustainability of full optimal rule (H21) |
| Without stochastic disturbances (C69) | Undermined credibility of policy announcements (E60) |
| Presence of stochastic disturbances (C62) | Credibility of time-inconsistent policies (D15) |