Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Encountering time inconsistency

Discretionary policy may also not be a good idea in that it can lead to what economists call time inconsistency. This is the idea that you make a plan today about what you’re going to do in the future; however, when the future arrives, you want to change your plan and do something else.

Here’s a good way of thinking about it. Imagine that your house is in need of a tidy. You don’t want to do it now, but you make a plan that you’ll do it tomorrow. However, tomorrow arrives, and if you have discretion, you face the same choice as you faced yesterday: should I tidy now or delay it another day? Since you chose to delay yesterday, what makes you think that you won’t delay again today?!


To build or not to build

Some parts of the country experience regular floods. Policy makers, wishing to discourage people from building homes on floodplains, announce, ‘If you build a house here, the next time it floods you’re on your own.’

The problem is, when a flood occurs, the media descend and show the difficulties people are facing. Then politicians face irresistible pressure to renege on their earlier announcement and help rebuild. Knowing this, people discount the announcement and build anyway.

It’s clearly not optimal to build a house on a floodplain and then for the taxpayer to regularly

pay for the damage. What would be much better is if policymakers were able to tie their hands and bind themselves to not help rebuild. Households, understanding that they really will be on their own when a flood occurs, decide to build elsewhere. Now no homes are flooded, there’s no media furore and no taxpayer money is wasted – everyone wins!

Inflation bias

We now apply the time-inconsistency problem to some economic policy problems. Policy makers face a short-run trade-off between unemployment and inflation (as we discuss in Chapter 12 and show in the Phillips curve). That is, they can reduce unemployment temporarily by creating ‘surprise’ inflation (see Figure 13-1).

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Figure 13-1: The Phillips curve.

Assume that a policy maker who dislikes inflation and unemployment carries out policy according to the following three stages:

1.