Question

What is the time-inconsistency problem? Is an independent central bank the solution? 'The economy's behaviour differs radically under rational and adaptive expectations' Discuss 2. 3. Does monetary feedback policy have no effect on the economy's output under rational expectations? Compare and contrast the effects of a rise in government spending on an economy under a) fixed and b) floating exchange rates. 5. Explain the workings of the Classical Model. What would the model imply for the economy if there was a rise in the money supply

Answer 1

1. The concept of time inconsistency is closely related to the field of Behavioral economics. It can be defined as a situation in which a person's preferences or decisions change over a period of time in such a way that they become inconsistent over any other point of time. In specific terms, time inconsistency arises when there is an incentive for an agent to deviate from a contract made with another agent even when no news has emerged. The problem of time inconsistency is a non cooperative game between the private sector and the government. Here, the private sector plays the wage setting athourity whereas the government acts as the policy maker i.e. the Central Bank. The private sector's bargaining power is depends upon the inflation expectations it derives from the monetary announcements of the Central Bank. When the wage contracts are agreed upon, there remains the incentive for the Bank to exploit the short run Phillips curve trade off by creating surprise inflation. In such a situation, there are three possible outcomes.

a. Time inconsistent equilibrium. The policy maker is in a position to cheat the private sector to push inflation thus reducing real wages. Corresponding to this, the private sector makes decision covering the costs of being cheated. Equilibrium is reached when, there is no incentive of the Bank to further increase inflation rate and is no output gain associated with this rate.

b. Technology. If there is appropriate commitment technology available, the second best equilibrium is reached. Although the policy maker could be placed on a lower value of its loss by cheating, the private sector employs an enforcement mechanism which prevents it from doing so. This outcome is known as optimum rule equilibrium.

c. The final equilibrium is arrived when the same game played an indefinite number of times. This equilibrium exists somewhere between the second and third best outcomes.

The best and the most appropriate solution to the time inconsistency problem is the independence of the Central Bank overriding the objective of Price Stability of the government. An independent central bank would not be in the best interest to create surplus inflation. This increases its credibility in the eyes of the private sector.