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Time consistency

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In the world of economics, the idea of time consistency is most closely linked to the age-old debate over rules versus discretion. As Taylor notes, economists since Adam Smith and David Ricardo have proposed rules for monetary policy.

But the work on time consistency established an important intellectual basis for advocating rules, while emphasizing the importance of a broad framework for constraining discretion in a way that makes policy commitments credible. Monetary policy. The time consistency problem is perhaps nowhere more widely acknowledged than in the case of monetary policy.

That is why modern central banks constantly discuss strategy and commitment, and work to design a framework for decision-making and communications that ensures credibility. The problem is simple. Suppose that the mere promise of price stability persuades price- and wage-setters to set steady prices and wages.

In that event, a monetary policymaker with a short horizon has an incentive to ease policy and boost economic activity. Knowing this, however, price- and wage-setters have little reason to believe the initial announcement. So, how can central bankers make their commitment to price stability credible?

One way is to ensure that their horizon is long enough that they will not forsake the long-term goal of low inflation for the short-term benefit of a temporary boom. Over the past quarter century, this compelling logic has led governments in much of the world to delegate monetary policy to independent central banks with legally mandated objectives, overseen by officers with long terms. To enhance policy effectiveness, central bankers themselves developed a regime of inflation targeting based on constrained discretion.

At the same time, scholars like Taylor, as well as legislators, have proposed specific policy rules to further limit discretion. Today, inflation targeting is—de jure or de facto—the prevailing monetary policy regime in countries that produce about two thirds of global GDP. Inflation targeting relies on transparency and communication to raise the cost of reneging on the price stability commitment.

Policymakers not only announce a quantitative target for inflation over at least the next several years, but they routinely report publicly on their progress in realizing their objective. And, when they adjust their instruments, central bankers justify their actions in terms of the impact it will have on achieving their commitment. Indeed, central banks now view transparency as an essential tool for effective policymaking. While the Federal Reserve did not announce a numerical inflation target until , it behaved as if it had an inflation-targeting framework at least since Over this period, U.

In contrast, from to , inflation averaged 5. To see the implications, consider the following chart that shows the real oil price adjusted for consumer prices and a survey measure of one-year-ahead inflation expectations. When oil prices spiked in the s, inflation expectations moved accordingly. By contrast, since , inflation expectations show little sensitivity to large swings in the real oil price. Too big to fail.

For several decades, and especially in the aftermath of the financial crisis of , one of the largest problems facing prudential regulators has been that of too big to fail TBTF. See for example, Stern and Feldman. To prevent a financial collapse and another Great Depression, regulators in the United States and elsewhere have repeatedly used public money to bail out the creditors of the largest, most connected, and most complex intermediaries.

In addition to popular revulsion, these bailouts have created moral hazard —encouraging financial behemoths to take risks in good times that make the system more vulnerable to crisis. It is tempting for policymakers merely to pass legislation banning bailouts. House last year, takes exactly this tack. However, as we have argued before , this approach is destined to fail.

Mere promises lack credibility and will not constrain the risk-taking behavior of TBTF firms. When push comes to shove, in a crisis, policymakers will come under overwhelming pressure to prevent a financial collapse through bailouts. If necessary, future legislators will enact new laws repealing anything in place.

Anticipating a bailout should disaster strike again, TBTF firms profit today from systemically risky activities. In short, TBTF is a problem of time consistency. Only a regulatory regime that forces financial behemoths to internalize the spillovers of their behavior on to the financial system as a whole will credibly contain the TBTF problem.

See our earlier discussion here. In our view, such a regime has three components: high capital requirements that force intermediaries to self-insure against losses; stress tests that ensure capital adequacy even under the most severe adverse conditions; and an effective resolution regime that provides for automatic recapitalization of weakened behemoths as well as temporary government provision of resolution funding.

The point is that the only way to prevent a future bailout is to ensure that the alternative is not an economic disaster. Capital taxation. A basic rule of public finance is that taxing goods that are supplied or demanded inelastically minimizes the deadweight losses from taxation. This creates a dangerous temptation for policymakers in search of revenue: once firms have made large investments in plant and equipment, tax their immobile capital stock.

Gruber, J. The Quarterly Journal of Economics, — Laibson, D. Quarterly Journal of Economics , — In: Encyclopedia of Cognitive Sciences. Nature Publishing Group, London Mischel, W. Science , — Parfit, D. Oxford University Press Phelps, E. Review of Economic Studies 35, — Rohde, K.

Journal of Risk and Uncertainty 41, — Saez Marti, M. Journal of Economic Theory , — Samuelson, P. The Review of Economic Studies 4 2 , — Sozou, P. Proceedings of the Royal Society, London , — Download references. You can also search for this author in PubMed Google Scholar. Reprints and Permissions. Dimitri, N. Time Discounting and Time Consistency.

In: van Eijck, J. Lecture Notes in Computer Science, vol Springer, Berlin, Heidelberg. Publisher Name : Springer, Berlin, Heidelberg. Print ISBN : Online ISBN : Anyone you share the following link with will be able to read this content:. Sorry, a shareable link is not currently available for this article.

Provided by the Springer Nature SharedIt content-sharing initiative. Skip to main content. Search SpringerLink Search. Abstract Time discounting is the phenomenon that a desired result in the future is perceived as less valuable than the same result now.

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Lecture 5: Dynamic Inconsistency and Credibility in Monetary Policy

Time consistency refers to when you make a commitment to take an action in the future. If the incentive to keep the commitment is the same as the incentive. Time consistency in the context of finance is the property of not having mutually contradictory evaluations of risk at different points in time. This property implies that if investment A is considered riskier than B at some future time, then A. Time consistency in the context of finance is the property of not having mutually contradictory evaluations of risk at different points in time.