DP536 Which `Simple' Rules Rather than Discretion?

Author(s): Daniel Cohen, Philippe Michel
Publication Date: March 1991
Keyword(s): Credibility, Macroeconomic Policy, Time Inconsistency
JEL(s): 130, 310
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=536

The dynamic inconsistency of a government's preferred policy, when it occurs, usually implies that the maximum level of welfare that can be delivered at some initial time can only be attained by constraining the economy to `low' levels in the future. In this paper, we set up a linear quadratic model in which the `best' policy rule which is looked for today is subject to the constraint of always delivering in the future a given reservation level of welfare which in equilibrium is the level that the `best' policy itself offers to deliver. We fully characterize the solutions to this problem in the cases when the government policies are constant, linear and kinked linear.