Time Inconsistency Theory And Monetary Policy Implications

Kydland and Prescott applied the optimal control theory to economic policy and pointed out the time-inconsistency problem of optimal policy. In a discretionary regime the policymakers can create surprise inflation, which may reduce unemployment. However, the private sector forms expectations rationally. In equilibrium the inflation is excessive but the unemployment rate does not fall down below the natural rate, that is, the discretionary equilibrium is not optimal. The reason of the sub-optimal result lies in the incredibility of the commitment of zero- or low inflation. Thus, in order to solve this problem, the policymakers should make a pre-commitment and improve the credibility of monetary policy. This essay analyzed the time-inconsistency theory and its adoption in monetary policy, introduced several methods widely-accepted by economists, further pointed out the great importance of independence of central bank in solving the time-inconsistency problem, and discussed a new monetary policy frame, i.e. inflation-targeting, in the end, aiming at combining its favorable parts with the practical situation in China to improve the performance of our monetary policy.