In previous chapters we considered optimal monetary policy in an economy subject to exogenous shocks. The optimal strategy each period depended on the structure of these stochastic shocks. The monetary policy problem was essentially a game against nature. In the models in Chapters 4 and 5, however, where expectations are rational, the responses of economic agents to policy actions could make those actions ineﬀective. Policymakers in these models appeared irrational (or uninformed). They pursued output stabilization goals even in environments where real output was independent of systematic policy. This fact stimulated interest in a positive theory of policymaker behavior and led to models where policymakers optimized with a recognition that economic agents had rational expectations. Both policymakers and private sector agents act strategically. In such an environment, the potential for time inconsistencies arises. As Stanley Fischer (1990, pp. 1169–70) explains, a time (or dynamic) inconsistency “occurs when a future policy decision that forms part of an optimal plan formulated at an initial date is no longer optimal from the viewpoint of a later date, even though no new information has appeared in the meantime”. If a policy is time-inconsistent, agents forming rational expectations will not believe that the policy will be implemented; the policy will not be credible. Let us begin by considering the time inconsistency problem related to monetary policy ﬁrst examined by Kydland and Prescott (1977). Suppose that as of a point in time (t) the optimal policy is a feedback rule mt ϭ mtϪ1 ϩ ␣1vt...
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