Time Consistency of Monetary and Fiscal Policy

A (possibly time-and state-contingent) strategy is said to be time inconsistent if an agent finds it optimal from the point of view of some initial period 0 but finds it suboptimal in some subsequent period t. Time inconsistency can obviously arise if the government has time-varying preferences because of alternations of government, as shown in Persson and Svensson (1989). However, as Kydland and Prescott (1977) discovered, the time-inconsistency problem is a pervasive feature of environments with a single benevolent policymaker taking decisions over time. This happens even though the policymaker has stable preferences and even in situations where there is no apparent conflict of interest — though the emphasis there should perhaps be on the word ‘apparent’. This means that everyone in the economy can often be made better off if the policymaker gains access to a commitment technology — a mechanism that forces him or her to keep his or her promises.