To breed an animal with the right to make promises – is not this the paradoxical task that nature has set itself in the case of man? (Friedrich Nietzsche, 1887) INTRODUCTION The last chapter’s analysis largely argues against activist monetary policy. We saw, for example, that reduced form evidence oﬀers little guidance to activist policy. Moreover, even if policy could fully eliminate business cycles, consumers may place a negligible value on marginal increases in economic stability. The present chapter turns this analysis in a more positive direction. Here, we’ll address the important question of why, despite discouraging arguments against policy activism, monetary authorities can maintain a strong incentive to actively inﬂate. This paradox emerges from the problem of ‘time inconsistency’: The problem in a nutshell is as follows: The best policy plan has the property that after following the plan for a while, everybody agrees that there is a better alternative than to continuing the original plan. But, if a group of people cannot commit to its original plan, the ex ante best plan [that which initially appeared optimal] is not feasible. (Edward C. Prescott, quoted by Rolnick, 1996) We’ll argue that the ‘ex ante best plan’ is a policy that produces price stability. Notice, however, that once individuals anticipate such a policy, expectations in the Lucas supply curve are ﬁxed. At this point, the monetary authority has an opportunity to trade inﬂation for employment (this opportunity does not exist before expectations are formed). Despite the optimality of...
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