Teaching Time-Inconsistency Consistently

Abstract

This paper places Kydland and Prescott's classic analysis of time inconsistency in a fuller context by examining their result in five different economic environments. Pedagogically, the paper uses a consistent mathematical treatment of the subject throughout. To understand the motivations of the central bank, the paper begins with the environment that Kydland-Prescott successfully criticized wherein the public has static inflationary expectations and the central bank assumes that they do. The main sections of the paper go on to analyze time inconsistency in four alternative environments defined by the belief structure of the central bank with respect to the nature of the economy and the mechanism by which the public forms its inflationary expectations. It is shown that the inconsistency result holds when the central bank does not understand the natural rate hypothesis and does not believe that the public forms their inflationary expectations rationally. The inconsistency result, however, does not hold in the other cases.