Question

A. What is meant by “time inconsistency of discretionary policies” ? What is the problem with it? Give an example of time inconsistency.

B. What is moral hazard? How do financial institutions deal with moral hazard? (2 marks)

Answer 1

A. Time inconsistency of discretionary policies essentially means the policies undertaken are not as per expectations. Discretionary policies means flexible policies which the government undertakes to increase/reduce the expenditure as and when needed.

For example a government announces to reduce taxes in the long run, but when the announcement is due they fall back stating that revenue collection has been low and that the government can't afford to cut back on tax rates. Thus policymakers are inconsistent over time.

The problem with this is that firms and other private organisations distrust future policy announcements and thus do not base their current investment and consumption decisions on future announcements.

B. Moral hazard occurs when a firm increases its risk exposure because it does not bear the full risk if the venture fails. Insurance schemes act as a cover for the risk. Thus the chances of risk taking increases.

Financial institutions deal with moral hazard by reducing asymmetric information and not insuring the full amount of the loss so that the firm will have to shell out some amount for the risk. Regular monitoring also goes a long way in dealing with moral hazard.