Time Inconsistency Model - Essay Example

Time inconsistency model Introduction Kydland and Prescott exposed inherent flaw of credibility problems–in the ability of governments to implement desirable economic policies and also concerns business cycle fluctuations (Blackburn & Christensen, 1989). Kydland and Prescott established how variations in technological development–the main source of long-run economic growth–can lead to short-run fluctuations. When they offered a new and operational paradigm for macroeconomic analysis based on microeconomic foundations. (Mankiw & Taylor, 2008). Kydland and Precsott’s work has transformed academic research in economics, as well as the practice of macroeconomic analysis and policymaking. (Miles, & Scott, 2005) A General Framework for Evaluation of Policy Rules Many types of models used for evaluating monetary policy (Mishkin, 2009) rules including small estimated or standardize models with or without rational expectations, optimizing models with representative agents, and large econometric models with rational expectations (King,1997). These models can be categorized into many areas such as closed economy models , open economy models, and multi-country models. Of course formal modeling is also usefully supplemented with historical or comparative analysis across countries. Seeking toughness of the rules across a wide range of models, viewpoints, historical periods, and countries is what’s advocated under the model. In itself TIM is an important paradigm for monetary policy evaluation research (Bryant, Hooper and Mann,1993 and McCallum,1999). Despite the differences in the models, there are some important common features as follows. 1. Interest rate elasticities matter. 2. The models are general equilibrium models in the sense that they describe the behavior of the whole economy. 3. The models incorporate fluctuating wages or prices. Kydland and Prescott considered a dynamic, stochastic general equilibrium model. Equilibrium in the model is a stochastic process for quantities and prices such that given the price, consumers and firms choose quantities in order to maximize the level of utility and maximize profits and then markets clear. In the dynamic model, unbiased predictions of the future evolution of prices are an element of optimizing behavior of both the producer and the consumer. Basic theorems ensuring the existence of an equilibrium–which, mathematically, required solving a fixed-point problem in high-dimensional space–were already provided in the work of Arrow and Debreu (see Debreu, 1959). However, a precise characterization of equilibrium was very difficult, due to the complexity of dynamic stochastic analysis. Thus, Kydland and Prescott’s 1982 paper made several simplifications of the general structure described by Arrow and Debreu. Kydland and Prescott considered only one consumption good and one type of “infinitely lived” consumer. Moreover, as in the standard neoclassical growth model, Kydland and Prescott assumed only one type of production technology and an aggregate production function, based on the inputs of capital and labor. They also assumed that markets are devoid of frictions, so that any equilibrium is Pareto optimal. This facilitated matters in the sense that standard welfare theorems allowed them to find and characterize the equilibrium using optimization theory. Since equilibrium delivered the best possible outcome for the representative consumer, they could sidestep the price mechanism and find the equilibrium quantities directly by solving a “social planning problem”. Based on these quantities, the equilibrium prices were then easily retrieved from the first order conditions for utility and profit maximization. In spite of these drastic simplifications, Kydland and Prescott found it necessary to use numerical analysis to characterize the equilibrium. In so doing, they adapted available insights in numerical analysis to the problem at hand and used computer-aided model solution. Today’s arts of the business cycle models are significantly more complex than that analyzed by Kydland and Prescott. Comparison of the model to data was another challenging task. A standard economical approach, to choose the model’s parameters to obtain the best possible fit to the business cycle data which may not used due to the model complexity and it may leads generate model output for even one set of parameter values was quite tricky and time-consuming. For overview, see Amman, Kendrick, and Rust (1996). A numerical solution of a dynamic, stochastic optimization problem is not easy. For doing that Kydland and Prescott adopted the method of “calibration”. Calibration is a simple form of estimation, since the model parameters are chosen in a well-specified algorithm to fit a division of the overall data. The estimation is based on microeconomic and (long-run) macroeconomic data in practical way (Snowdon & Vane, 2005). It allowed parameterization without solving the full model but allows make any changes when necessary. Time inconsistency model and inflation bias 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’’ (Hall,1983). 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 (Snowdon, 2007). 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 government’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). When an expectations-augmented Phillips curve model is taken into account with sticky nominal wages, the outcomes are clear. 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 doesn’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 (Blanchard, 2009). 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. Therefore the optimal policy, subject to this incentive constraint, equates the marginal cost of higher inflation with the marginal benefit of reduced unemployment. If the policymaker’s choice 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. Conclusion Time inconsistency model has given rise to a number of complex implications. In the first instance it has developed a more time specific approach to understanding how monetary policy will lead to equilibrium with an ‘inflation bias’. Most important in my view are more extensive toughness testing of simple rules and modeling how the move to a single currency will change the wage and price determination equations in the multi-country model where used. The research report shows the efficiency and toughness of simple policy rules in which the reaction of the interest rate to inflation is above a still critical. It appears as a simple standard rule. REFERENCES 1. Blackburn, K & Christensen, M 1989, ‘Monetary Policy and Policy Credibility’, Journal of Economic Literature, vol.27, no.1, pp.1-45. 2. Blanchard, OJ 2009, Macroeconomics, 5th edn, Prentice Hall, New Jersey, chapter 24. 3. Hall, RE 1983, ‘Optimal Fiduciary Monetary Systems’, Journal of Monetary Economics, vol.12, pp.33-50. 4. King, M 1997, ‘Changes in UK Monetary Policy: Rules and Discretion in Practice’, Journal of Monetary Economics, vol.39, pp. 81-97. 5. Kydland, FE & Prescott, EC1977, ‘Rules Rather Than Discretion: The Inconsistency of Optimal Plans’, Journal of Political Economy, pp. 473-91. 6. Mankiw, NG & Taylor, M 2008, Principles of Macroeconomics, South-Western College, Ohio, Chapter 14. 7. Miles, D & Scott, A 2005, Macroeconomics, John & Wiley Sons, New Jersey, pp.415-430. 8. Mishkin, FS 2009, Monetary Policy Strategy, MIT Press, Massachusetts. 9. Snowdon, B & Vane, HR 2005, Modern Macroeconomics, Edward Elgar Publishing, Cheltenham, Chapter 5. 10. Snowdon, B 2007, ‘The New Classical Counter-Revolution: False Path or Illuminating Complement?’, Eastern Economic Journal, vol.33, no.4, pp.541-62. Read More