Credibility and Time Inconsistency
A central bank free to re-optimise each period faces a time-inconsistency problem. It is tempted to spring surprise inflation for a short-run output gain, but rational people anticipate this, so the economy lands with higher inflation and no extra output. Rules, credibility, and central bank independence are the standard remedy.
Why it matters
This is the classic time-inconsistency result of Kydland and Prescott, sharpened into the inflation bias by Barro and Gordon. If everyone knows you will be tempted to renege later, they price it in now, so reneging buys nothing and only costs credibility. Committing to a rule, or delegating to an independent inflation-focused central bank, removes the temptation.
Worked examples
A central bank promises 2% inflation but each period is tempted to over-stimulate for jobs. What is the equilibrium?
The public expects the over-stimulation and sets higher wage and price expectations in advance. Inflation drifts up with no lasting employment gain. This is the inflation bias of discretion.
Common mistakes
- ✗More discretion is always better. Unconstrained discretion invites the inflation bias, and a credible commitment can deliver lower inflation at no output cost.
- ✗An independent central bank is undemocratic. It is given an instrument under a legislated mandate, which improves outcomes while staying accountable.
Revision bullets
- •Discretion tempts surprise inflation, the time-inconsistency problem
- •Rational expectations turn it into an inflation bias
- •Rules, credibility, and independence are the standard remedy
Quick check
The inflation bias from time inconsistency arises because the public
Connected topics
Sources
- Mishkin (2018), Ch. 17Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Time inconsistency, the inflation bias, and the case for rules and central bank independence.