Question

3. What is meant by the “time inconsistency” of economic policy? Why might policymakers be tempted to renege on an announcement made earlier? How might this have applied to the bailouts and other programs proposed and implemented in response to the financial crisis and Great Recession?

* Refer Macroeconomics by Gregory Mankiw , 10th edition; Please explain the complete answer in a detailed way

Answer 1

The “time inconsistency” of economic policy refers to a change in the policy preference of the policy maker over time such that policy preference becomes inconsistent over time. For e.g. - Central bank may promise to maintain low inflation while it is also aware of the trade off between inflation and unemployment. Since actual inflation is a function of expectations, it makes sense to announce this policy of low inflation. But mere announcement is not credible. Once households form expectations of inflation, Central bank has an incentive to renege a low inflation target so as to spur up employment in the economy. But, if people understand this process, then they may not trust the central bank in the first place.

Policymaker may renege on an announcement made earlier to pursue a goal that conflicts with the goal made in the announcement. This is applicable to bailouts and other programs proposed to mitigate the effect of financial crisis. Suppose that government announces that it won't bail out any firm that goes bankrupt due to firm's own wrong investment. Ideally such an announcement should prevent firms to undertake risky investments. However, if the government plans to renege on the announcement then certainly firms will undertake risky investments and hence government will come out to save them when they go bust. In this case, government may have saved bankrupt firms to minimize the negative effect of the crisis.