DP138 Is Time-Inconsistent Behaviour Really Possible?

Author(s): Andrew Hughes Hallett
Publication Date: November 1986
Keyword(s): Policy Reoptimization, Precommitment, Rational Expectations, Time Consistency
JEL(s): 023, 026, 311
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=138

If private sector agents hold rational expectations, they will predict any future policy switches. Discounting the announced optimal policies, if they are not credible, will lead to a response which deprives the government of any incentive to renege on previous announcements and of the benefits of those announcements. Hence it is in the government's interest to offer a guarantee, forfeit on reneging, to overcome that discounting. That rules out time inconsistent behaviour since either the guarantee is acceptable (i.e. it is worth more than the incentive to renege) or it is not in which case the government is forced back onto the usual recursive (but time consistent) strategy. The time inconsistent solution is needed only to evaluate the required guarantee.