And people wondered, if we can explain the laws of the universe, can’t we explain the principles that should control the government? (Anthony Kennedy, US Supreme Court Justice, 2006 address to the ABA assembly, Honolulu, HI) INSTITUTIONS AND COMMITMENT We saw in Part III that ‘time inconsistency’ is problematic in that a policy’s optimality is sensitive to when one evaluates it. The policy that appears best before economic agents play actions can eventually appear sub-optimal as the policy unfolds. This change does not emerge from new information revealing itself over time, or from the preferences of policy makers and constituents diverging, but rather from the manner in which past actions change bargaining positions. As such, time inconsistency is a resistant problem that can leave maximizers able to commit to only suboptimal policies. In this section, we’ll investigate how monetary authorities can govern themselves in a manner that expands this set of commitments. Our model of the monetary authority’s problem (see Chapter 9) highlights a potentially fruitful direction – that is, implement governance features that either increase the cost of acting on inﬂationary incentives (to choose = 1) or discourage the maintenance of such an incentive in the ﬁrst place. To the extent that authorities successfully implement such features, constituents will rationally expect the socially optimal policy (for example, = 0 in Chapter 9’s model), and monetary authorities will fulﬁll that expectation. An interesting insight here is that maximizers can do better by increasing the cost of pursuing their incentives, or even...
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