Time-Consistent Institutional Design

This paper reconsiders normative policy design in environments subject to time inconsistency problems, a la Kydland and Prescott (1977). In these environments there are generally gains to making binding promises about future policy conduct, in the form of an institutional target or mandate. However decisionmakers at different points in time have different preferences about the best promises to make and to keep. We consider the implications of choosing these promises according to a Pareto criterion. A sequence of promises is Pareto efficient if there is no alternative sequence that all current and future policymakers would prefer to switch to. This criterion has the advantage that it can be applied recursively, in environments where, by definition, no policy is recursively Ramsey-optimal. Recursive Pareto efficiency thus provides an appealing normative alternative to standard Ramsey policy. We characterise outcomes in a general setting when promises are chosen to be recursively Pareto efficient. Three examples, explored throughout the paper, highlight how this approach to policy design avoids features of Ramsey policy that are commonly identified as problematic.