Wednesday, April 19, 2006

Time Inconsistency

My previous post mentioned the time inconsistency literature that began with Kydland and Prescott's Nobel-prize winning work. We haven't addressed this topic in ec 10 yet; I plan to talk about it in lecture in a couple of weeks. In the meantime, here is a primer, lovingly ripped off from my intermediate macroeconomics text.

The Time Inconsistency of Discretionary Policy

If we assume that we can trust our policymakers, discretion at first glance appears superior to a fixed policy rule. Discretionary policy is, by its nature, flexible. As long as policymakers are intelligent and benevolent, there might appear to be little reason to deny them flexibility in responding to changing conditions.

Yet a case for rules over discretion arises from the problem of time inconsistency of policy. In some situations policymakers may want to announce in advance the policy they will follow to influence the expectations of private decisionmakers. But later, after the private decisionmakers have acted on the basis of their expectations, these policymakers may be tempted to renege on their announcement. Understanding that policymakers may be inconsistent over time, private decisionmakers are led to distrust policy announcements. In this situation, to make their announcements credible, policymakers may want to make a commitment to a fixed policy rule.

Time inconsistency is illustrated most simply in a political rather than an economic example‑‑specifically, public policy about negotiating with terrorists over the release of hostages. The announced policy of many nations is that they will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping hostages, rational terrorists won't kidnap any. In other words, the purpose of the announcement is to influence the expectations of terrorists and thereby their behavior.

But, in fact, unless the policymakers are credibly committed to the policy, the announcement has little effect. Terrorists know that once hostages are taken, policymakers face an overwhelming temptation to make some concession to obtain the hostages' release. The only way to deter rational terrorists is to take away the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentive for terrorists to take hostages would be largely eliminated.

The same problem arises less dramatically in the conduct of monetary policy. Consider the dilemma of a Federal Reserve that cares about both inflation and unemployment. According to the Phillips curve, the tradeoff between inflation and unemployment depends on expected inflation. The Fed would prefer everyone to expect low inflation so that it will face a favorable tradeoff. To reduce expected inflation, the Fed might announce that low inflation is the paramount goal of monetary policy.

But an announcement of a policy of low inflation is by itself not credible. Once households and firms have formed their expectations of inflation and set wages and prices accordingly, the Fed has an incentive to renege on its announcement and implement expansionary monetary policy to reduce unemployment. People understand the Fed's incentive to renege and therefore do not believe the announcement in the first place. Just as a president facing a hostage crisis is sorely tempted to negotiate their release, a Federal Reserve with discretion is sorely tempted to inflate in order to reduce unemployment. And just as terrorists discount announced policies of never negotiating, households and firms discount announced policies of low inflation.

The surprising outcome of this analysis is that policymakers can sometimes better achieve their goals by having their discretion taken away from them. In the case of rational terrorists, fewer hostages will be taken and killed if policymakers are committed to following the seemingly harsh rule of refusing to negotiate for hostages' freedom. In the case of monetary policy, there will be lower inflation without higher unemployment if the Fed is committed to a policy of zero inflation. (This conclusion about monetary policy is modeled more explicitly in the appendix to this chapter.)

The time inconsistency of policy arises in many other contexts. Here are some examples:
  • To encourage investment, the government announces that it will not tax income from capital. But after factories have been built, the government is tempted to renege on its promise to raise more tax revenue from them.
  • To encourage research, the government announces that it will give a temporary monopoly to companies that discover new drugs. But after a drug has been discovered, the government is tempted to revoke the patent or to regulate the price to make the drug more affordable.
  • To encourage good behavior, a parent announces that he or she will punish a child whenever the child breaks a rule. But after the child has misbehaved, the parent is tempted to forgive the transgression, because punishment is unpleasant for the parent as well as for the child.
  • To encourage you to work hard, your professor announces that this course will end with an exam. But after you have studied and learned all the material, the professor is tempted to cancel the exam so that he or she won't have to grade it.

In each case, rational agents understand the incentive for the policymaker to renege, and this expectation affects their behavior. And in each case, the solution is to take away the policymaker's discretion with a credible commitment to a fixed policy rule.


PS to ec 10 students: There really, really is a test today. I will avoid temptation. I promise.