Working Paper: NBER ID: w26451
Authors: Alessandro Dovis; Rishabh Kirpalani
Abstract: This paper studies the optimal design of rules in a dynamic model when there is a time inconsistency problem and uncertainty about whether the policy maker can commit to follow the rule ex post. The policy maker can either be a commitment type, which can always commit to follow rules, or an optimizing type, which sequentially decides whether to follow rules or not. This type is unobservable to private agents, who learn about it through the actions of the policy maker. Higher beliefs that the policy maker is the commitment type (the policy maker's reputation) help promote good behavior by private agents. We show that in a large class of economies, preserving uncertainty about the policy maker's type is preferable from an ex-ante perspective. If the initial reputation is not too high, the optimal rule is the strictest one that is incentive compatible for the optimizing type. We show that reputational considerations imply that the optimal rule is more lenient than the one that would arise in a static environment. Moreover, opaque rules are preferable to transparent ones if reputation is high enough.
Keywords: No keywords provided
JEL Codes: E6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low reputation of the policy maker (D73) | lenient rules (K40) |
| high reputation of the policy maker (E60) | stringent rules (Z28) |
| high reputation of the policy maker (E60) | opaque rules (Y10) |
| lenient rules (K40) | compliance from optimizing type (D10) |
| stringent rules (Z28) | reveal policy maker's type (D79) |
| allowing for bailouts in equilibrium (D53) | maintain discipline among financial institutions (G28) |