DP63 Credibility and Commitment in Economic Policy

Author(s): David Backus, John Driffill
Publication Date: June 1985
Keyword(s): Atomistic Agents, Disinflation, Dynamic Consistency, Feedback Solution, Policy Credibility, Rational Expectations
JEL(s): 023, 311, 321
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=63

Dynamic inconsistency provides a theoretical basis for discussions of policy credibility: when the government cannot commit its future policies, the incentive to deviate from the 'optimal' plan renders it incredible. We derive the best policy in the absence of precommitment as the feedback Nash solution to a dynamic game between the government and a private sector composed of small agents. The solution is dynamically consistent by construction, and therefore credible. An application to disinflation shows that the feedback Nash policy may be considerably more costly than the 'optimal', but inconsistent policy. The analysis also reveals the source of the inconsistency of benevolent governments' policies.