According to the time inconsistency model article published by the 2004 Noble prize winners, Finn Kydland and Edward Prescott (1977), reveals that the use of discretionary monetary policy will lead to equilibrium with an ‘inflation bias’. In order to explain and determine how this fact was reached, we have to first explain what time inconsistency is. Time inconsistency can be referred to as when a law or rule that initially seemed most favourable at one point in time becomes unfavourable later in the future or the difference before the event and after the fact. A good example is governments none negotiating with terrorist rule. Government’s announces this rule with the primary intention to ...view middle of the document...
In trying to achieve this, there is a trade off i.e. the lower the rate of unemployment, the higher the rate of inflation. The Phillips curve shown above in appendix 1 identifies this cost and helps policy makers to reach decisions concerning this issue. This trade off however is only seen in the short run while in the long run, the only thing that changes is price (output unchanged) and the tradeoff between inflation and unemployment depends on expected inflation. This long run change in price gave rise to another problem known as the stagflation problem, i.e. a continued high rate of inflation may not possible be due to irrational policy decisions but may just be a reflection of government’s inability to commit to monetary policy.
Example, Policymakers announce in advance that their proposed policy will be to decrease inflation and the private sector after hearing this announcement acts on it and adjusts their expectation to suit this announcement. But later after the private sector has acted, the policymakers are faced with a serious dilemma. They now have an incentive to either follow through with their announcement and be credible or go back on it and cheat in order to implement an expansionary monetary policy which will reduce unemployment. In reality, most governments will cheat and raise inflation to reduce rate of unemployment below its natural rate. By the time private sector realizes that they have been cheated, they adjust their expectations back and the rate of unemployment returns back to its natural rate while there is a rise in inflation in the economy. Now, the central bank credibility has been tarnished and such announcements in the future will not be trusted. So, for them to regain the credibility back, they may want to make a commitment to a fixed policy rule or use the Ken Rogoffs model of 1985 i.e. the government should appoint a "conservative" central banker.
“Finn Kydland and Edward Prescott showed that government policymaking is subject to a time consistency problem through following Robert Lucas private sector expectation and also following Friedman and Phelps in assuming that those expectations are important determinants of economic outcomes” (Snowdon, B and R.V. Howard, 2005).
To show that using discretionary policies are unable to achieve an optimal equilibrium, we take a look at some equations.
Ux = Ux1 + V (Pt’ - Pt)…………………….. Equation 1
This equation represents the trade off issue faced by policy makers through the use of Phillips curve i.e. A rise in inflation can produce a reduction in unemployment.
U x is unemployment is time period t
Ux1 is the natural rate of unemployment
V is the positive constant
Pt’ is the expected rate of inflation in the time period t
Pt is the actual rate of inflation in the time period t
Pt’ = E(Pt I Ωt-1)........................... Equation 2
E (Pt I Ωt-1) is the rational expectation of the rate of...