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The major stepping stone in this aspect of research is to be found in Kydland and Prescott (1977). By making use of the conceptual insights of earlier methodological contributions, the concept of rational expectations initiated by Lucas and the more instinctive normative arguments of Friedman and Simon favoring simple rules, this paper reaches some astonishing but logically forceful and very general conclusions.
In a general dynamic setting, optimal policy regulations are not likely, because they are "time inconsistent": if the policy rule is believed and used to form expectations of future policy by private agents, the government has an enticement to depart away from it later on, inducing policy "surprises".
In a balance with rational private agents, such policy surprises are not considered. The equilibrium policy regulation must be enforcing on its own, as the feedback equilibrium talked about by Kydland. But once this solution theory is accepted, the policy rule creates a lower overall level of welfare.
In order to get out of this trap it is necessary to commit to a policy rule in advance. Discretion, namely a setting where policy is chosen one after the other over time, suffers from lack of credibility. Commitments that are not possible to reverse are valuable, as they lend credibility to policy and enable the policymaker to influence private sector expectations.
The contribution of Kydland and Prescott could be summarized and explained as given below. Think of an instance where there is disagreement of interest between the government and private economic agents. This disagreement could come about even if the government and the private sector have very similar preferences: if there are applicable economic externalities or if the government does not have non-distorting policy instruments, the equilibrium allocation is not efficient from the governmentââ‚¬â„¢s viewpoint.
At any time if there is such a conflict of interest, the government will utilize economic policy to influence private sector behavior and implement its preferred allocation. Officially, the government is the dominant player (or Stackelberg leader) in a game with (atomistic or large) private agents. In a dynamic economy, private behavior is dependent on the expectations of future economic policy. As a result, the capability to influence expectations is vital for policy success.
If the policy rule is chosen by the government once and for all, without re-planning after that, then rational private agents will adapt their expectations taking this policy rule into consideration, and the story ends here. On the contrary, if policy choice is sequential, and it is made period after period, then the policymaker is subject to an incentive restriction.
Private expectations will not adjust to any pre-announced policy rule. Instead rational expectations will indicate the equilibrium policy choice of future periods. Current policy decisions can only influence future expectations to the extent that current policies affect future equilibrium outcomes.
This enticement limitation limits what the government can achieve and thus resulting in reduced government welfare, compared to the situation in which binding policy commitments are possible.
Kydland and Prescott (1977) demonstrated their result with a couple of examples where policies brought about by a caring government are likely to suffer from time inconsistency: social insurance against natural disasters, patent protection for inventions, a simple monetary policy model of inflation and unemployment, and an optimal taxation problem in a dynamic economy. In all the examples given above, a successful policy must influence private sector expectations; however time inconsistency stops this from happening.
The monetary policy example addressed by Kydland and Prescott is especially renowned, also thanks to its popularization by Barro and Gordon (1983a,b). Take in to account an expectations-augmented Phillips curve model with sticky nominal wages. Here, monetary policy can decrease unemployment below the natural rate only if it creates a rate of inflation greater than expected.
In a static version of this model, current equilibrium inflation doesnââ‚¬â„¢t depend on past policy choices. Hence, the incentive constraint means that expected inflation is also a constant that must be taken as given by the policymaker setting monetary policy today. Instinctively, when monetary policy is set, nominal wages are already fixed by existing contracts and incorporate some expectations of forthcoming inflation.
This means that, when policy is set, there is a trade-off between inflation and unemployment: higher inflation leads to higher unexpected inflation and lower real wages and, thus, lower unemployment. The optimal policy, subject to this incentive constraint, as a result equates the marginal cost of higher inflation with the marginal benefit of reduced unemployment.
If the policy makerââ‚¬â„¢s motive is to cut down on unemployment below the natural rate, then this results in a positive inflation rate. However this policy is fully expected by private agents and, in equilibrium, expected inflation equals actual inflation. As a result, equilibrium unemployment stays equal to the natural rate as long as there is an inflation bias, that is equilibrium inflation is always above the target.
This inflation bias consequence comes about as the policymaker would like to cut down unemployment below the natural rate. However, as subsequent research has clearly indicated, lack of credibility brings about lower welfare, even if the policymaker's motive is to stabilize unemployment fluctuations around the natural rate and keep inflation close to a target, so that there is no systematic inflation bias.
Say, for example, that equilibrium unemployment is dependent on expectations of future inflation, rather than on current expected inflation. The incentive constraint continues to involve a constant expected inflation. However now, even without giving rise to a systematic inflation bias, this restriction limits the policymaker's ability to stabilize the economy in the face of aggregate supply-side shocks. Supply-side shocks refer to those developments related to the micro-economic concepts such as labor markets and their behavioral dynamics.