Time-Consistent Rules in Monetary and Fiscal Policy
- When households and businesses are uncertain whether or not a government policy will remain unchanged over its scheduled tenure, the outcome the policy aimed to achieve can be distorted by the public’s expectation of how strictly it will be enforced. How can you mitigate uncertainty so that the public will not adjust their response to it?
- One way of mitigating the uncertainty is to add time-consistent rules to new policies. When they are enacted, time-consistency rules make altering the policies very difficult in the future.
- Explain how election turnover can have an effect on how households and businesses respond to policies.
- In a democracy, no elected official's position is guaranteed. If a policymaker loses office, subsequent office holders may alter or even completely change the policies of their predecessors. For this reason, households and businesses can't be certain that a policy will remain unchanged over its scheduled tenure, and their response to the policy should adjust to reflect this uncertainty.
- Discuss how optimal policy depends on whether policymakers can commit to the policy. What does it mean when a policy is time-inconsistent?
- Finn Kydland and Ed Prescott wrote in a Nobel-prize winning paper that when households and businesses can rely on government policy, it helps them make decisions about how much income to save or how many workers to hire. But if a policymaker can't convince households that the policy it sets won't be changed (that is the government can't commit to policy in the future), households and firms will weigh the possibility that policy may change. This can temper their actions and can alter the effectiveness of the original policy. Generally, policymakers can't commit, therefore, optimal policy with commitment most often is time-inconsistent. This means that at some point in the future the government will be tempted to change its policy. Even though the policy seemed optimal in the past, once the future arrives, the government no longer finds it desirable to follow its original plan.
- Explain a scenario in which the dilemma of time-inconsistency appears directly in the conduct of monetary and fiscal policy.
- There is a democratically-elected government that has an incentive to provide more resources to its constituents through spending and transfers (promised payments to subsets of a population, such as social security), but doing so requires financing. Taxation is probably the least desirable because voters react negatively when their take home pay shrinks. Historically, inflation is a more attractive revenue source for politicians. Voters may not immediately be able to distinguish growth from inflation and so recognize what the government has done. However, when they become savvy to inflationary policy, they will expect future inflation to be higher, increasing inflation expectations and raising the nominal interest rate. This makes the government’s cost of servicing the debt larger, and its need for financing even greater, ultimately leading to a world characterized by high inflation rates and high expected inflation.
- Give examples of the effects that an independent central bank may have on inflation.
- A widely-used measure of independence designed by Cuckierman, Webb, and Neyapti (1992) is based on four categories:
The limitations placed on the central bank in regards to lending to the government.
- The degree to which the head of the central bank is sheltered from the executive and legislative branches of government.
- The degree to which a central bank has exclusive authority over monetary policy and indulgence over the budget process.
- The concentration of the central banks’ mandate on price stability.
- How do you make time-consistent rules work?
- The key to making time-consistent rules work is to make violating the commitment costly. Without meaningful penalties, governments can ignore rules. In addition, penalties should be enforced from outside the government, for example by the market. Independent central banks satisfy this criterion because they act as a signal to the market of the government’s stance on inflationary monetary policy.