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Credibility and Time Inconsistency in a Stochastic World

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  • Currie, David
  • Levine, Paul L

Abstract

This paper re-examines the issue of the credibility and sustainability of optimal policies derived from Pontryagin's Maximum Principle and generally regarded as time-inconsistent, in models with forward-looking rational expectations. Specifically, it considers the behaviour of such models in the presence of continuing stochastic noise. This is shown to convert the policy problem from a one-shot dynamic policy game to a continuing game, giving governments an incentive to invest in a reputation for not reneging on the full optimal rule. This incentive may, in certain circumstances, render the full optimal rule credible and therefore sustainable. It is demonstrated that a sufficiently low degree of discounting on the part of government, or a sufficiently high variance of shocks (measured relative to the initial displacement) ensures the sustainability of the full optimal rule. Using a simple dynamic open economy model, these conditions are shown to be plausible unless the discount rate is very high.

Suggested Citation

  • Currie, David & Levine, Paul L, 1986. "Credibility and Time Inconsistency in a Stochastic World," CEPR Discussion Papers 94, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:94
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    Citations

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    Cited by:

    1. M. Isabel García Gracia, 1995. "El SME: un modelo de comportamiento asimétrico," Estudios de Economia Aplicada, Estudios de Economia Aplicada, vol. 3, pages 41-68, Junio.
    2. Juha Kilponen, 2004. "Robust expectations and uncertain models – A robust control approach with application to the New Keynesian economy," GE, Growth, Math methods 0404004, University Library of Munich, Germany.
    3. Warwick J. McKibbin & Jeffrey D. Sachs, 1986. "Comparing the Performance of Alternative Exchange Arrangements," NBER Working Papers 2024, National Bureau of Economic Research, Inc.
    4. Cristiano Cantore & Vasco J. Gabriel & Paul Levine & Joseph Pearlman & Bo Yang, 2013. "The science and art of DSGE modelling: II – model comparisons, model validation, policy analysis and general discussion," Chapters, in: Nigar Hashimzade & Michael A. Thornton (ed.), Handbook of Research Methods and Applications in Empirical Macroeconomics, chapter 19, pages 441-463, Edward Elgar Publishing.

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