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Credibility and Commitment in Economic Policy

Author

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  • Backus, David
  • Driffill, John

Abstract

Dynamic inconsistency provides a theoretical basis for discussions of policy credibility: when the government cannot commit its future policies, the incentive to deviate from the 'optimal' plan renders it incredible. We derive the best policy in the absence of precommitment as the feedback Nash solution to a dynamic game between the government and a private sector composed of small agents. The solution is dynamically consistent by construction, and therefore credible. An application to disinflation shows that the feedback Nash policy may be considerably more costly than the 'optimal', but inconsistent policy. The analysis also reveals the source of the inconsistency of benevolent governments' policies.

Suggested Citation

  • Backus, David & Driffill, John, 1985. "Credibility and Commitment in Economic Policy," CEPR Discussion Papers 63, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:63
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    Cited by:

    1. Alberto Ortiz & Federico Sturzenegger, 2007. "Estimating Sarb'S Policy Reaction Rule," South African Journal of Economics, Economic Society of South Africa, vol. 75(4), pages 659-680, December.

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