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Time-inconsistency, Democracy and Optimal Contingent Rules

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  • Minford, Patrick

Abstract

Following Kydland and Prescott's (1977) seminal paper on time-inconsistency, a large literature has explored possible frameworks within which monetary policy could overcome this problem -- neatly illustrated in Barro and Gordon's (1983) model. In a stochastic world there appears to be a trade-off between the necessary `tying of hands' to conquer the effects of time-inconsistency and the desirability of flexible response. It is in principle possible to achieve an optimal outcome by use of a discriminatory punishment, however, with a large punishment (sufficient to deter) for using policy to exploit the Phillips curve to reduce unemployment below the natural rate, but no punishment for contingent response to shocks using the same Phillips curve. This paper sets out a model of democratic elections in which floating voters may find it optimal to follow this strategy. The significance of this possibility is that regimes which permit contingent macroeconomic policy responses, while enabling prior targets to be set and policed, are superior to those which do not. This has relevance to the debate over the Exchange Rate Mechanism and the European Monetary Union.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 767.

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Date of creation: Feb 1993
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Handle: RePEc:cpr:ceprdp:767

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Keywords: Discriminatory Punishment; Elections; Monitoring; Rules Versus Discretion; Time Inconsistency; Tying of Hands;

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Cited by:
  1. Iannis A. Mourmouras & Michael G. Arghyrou, 1999. "Monetary Policy at the European Periphery. Greek Experience and Lessons for Transition Economies," CERT Discussion Papers 9910, Centre for Economic Reform and Transformation, Heriot Watt University.
  2. Mariano Tommasi & Carlos Scartascini & Ernesto Stein, 2010. "Veto Players and Policy Trade-offs. An Intertemporal Approach to Study the Effects of Political Institutions on Policy," Working Papers 101, Universidad de San Andres, Departamento de Economia, revised Mar 2010.
  3. Lippi, Francesco & Swank, Otto H., 1999. "Rational Voters, Elections, and Central Banks: Do Representative Democracies Need Nonrepresentative Institutions?," Journal of Policy Modeling, Elsevier, vol. 21(4), pages 515-525, July.
  4. Herrendorf, Berthold, 1998. "Inflation Targeting as a Way of Precommitment," Oxford Economic Papers, Oxford University Press, vol. 50(3), pages 431-48, July.

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