Question

A. what is mean by "time inconsistency of discretionary policies" what is the problem with it? Given an example of time inconsistency.

B. What is moral hazard? How do financial institutions deal with moral hazard?

Answer 1

Answer-A)

The time inconsistency refers to a scenario where in the policymakers earns an incentive to renege on a previously announced policy when the people and firms have already acted on that announcement. With the discretionary policy the time-inconsistency problem occurs because economic behavior will be influenced by what the individuals and firms are expecting the monetary authorities to do in the future

Examples:

-- For promoting the investment, government announces it won’t tax income from capital. However when the factories are built, government reneges with a goal to raise higher tax revenue.

-- For decreasing the expected inflation, Fed announces to tighten monetary policy however faced with high unemployment; Fed may be tempted to reduce the rate of interest.

-- An aid to poor nations is contingent on fiscal reforms. The reforms would not occur, however the aid is provided as the donor nations don’t want the citizens of poor nations’ to starve

As per policy we have to answer first question