DP27 Dynamic Games and the Time Inconsistency of Optimal Policy in Open Economies

Author(s): Marcus Miller, Mark Salmon
Publication Date: August 1984
Keyword(s): Continuous-Time Economic System, Fiscal Stabilization, Full-Information Differential Games, Maximum Principle
JEL(s): 133, 213, 420
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=27

In this paper the Maximum Principle is used to derive optimal policies for linear-quadratic, continuous-time economic systems where there may be more than one policy-maker and where the private sector may have rational expectations. The analogy between solving full-information differential games and designing policy in the presence of forward-looking expectations is explored first, before these two problems are considered in combination. Both the "term inconsistent" optimal policy which arises from strategic asymmetries, and various time consistent alternatives are discussed; and the approach is illustrated with an application to fiscal stabilisation policy in a Common Market.