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Recursive macroeconomic theory, Thomas Sargent 2nd Ed - Chapter 22

Chapter 22 Credible Government Policies 22.1. Introduction The timing of actions can matter. 1 Kydland and Prescott (1977) opened the modern discussion of time consistency in macroeconomics with some examples that show how outcomes differ in otherwise identical economies | Chapter 22 Credible Government Policies 22.1. Introduction The timing of actions can matter.1 Kydland and Prescott 1977 opened the modern discussion of time consistency in macroeconomics with some examples that show how outcomes differ in otherwise identical economies when the assumptions about the timing of government policy choices are altered. In particular they compared a timing protocol in which a government determines its possibly state-contingent policies once and for all at the beginning of the economy with one in which the government chooses sequentially. Because outcomes are worse when the government chooses sequentially Kydland and Prescott s examples illustrate the value to a government of having access to a commitment technology that binds it not to choose sequentially. Subsequent work on time consistency focused on how a reputation can substitute for a commitment technology when the government chooses sequentially.2 The issue is whether incentives and expectations can be arranged so that a government adheres to an expected pattern of behavior because it would worsen its reputation if it did not. The folk theorem states that if there is no discounting of future payoffs then virtually any first-period payoff can be sustained by a reputational equilibrium. A main purpose of this chapter is to study how discounting might shrink the set of outcomes that are attainable with a reputational mechanism. Modern formulations of reputational models of government policy exploit ideas from dynamic programming. Each period a government faces choices 1 Consider two extensive-form versions of the battle of the sexes game described by Kreps 1990 one in which the man chooses first the other in which the woman chooses first. Backward induction recovers different outcomes in these two different games. Though they share the same choice sets and payoffs these are different games. 2 Barro and Gordon 1983a 1983b are early contributors to this literature. See Kenneth Rogoff .