Government indifference curves and time inconsistency

Explain the concept of dynamic inconsistency. Is the condition of the government aiming at a level of output above the level consistent will full employment crucial? Does the introduction of an electoral cycle, with uncertainty over the outcome of the elections exacerbate the problem? To understand the concept if time inconsistency the optimal policy of government and wage and price setters needs to be considered.

It would seem obvious that it is preferable for both of these organisations to operate within an economy characterised by low inflation and full employment. But Kydland and Prescott argue that there is an incentive for the government to cheat and deviate from the plan that was agreed with the wage and price setters. Since these wage and price setters are rational they realise that this is the case (if it has occurred once before), and they adjust their expectations to incorporate the expectation that the government will cheat.

But if wage and price setters lock themselves into contracts, committing themselves to SRAS0 (short run aggregate supply curve), in the diagram below, then the government incentive to cheat leads to a movement from point A to B so that the government can benefit from higher inflation (with higher monetary growth). The benefit can be seen from the fact that the government is now on a higher indifference curve since it has temporarily boosted the economy to achieve a rise in its popularity (specific at the point of reneging equilibrium B).

Government indifference curves and time inconsistency But since rational wage and price setters, and wish to maximise their own benefits, their realise that when the government announces its inflation target, this is false. Therefore, their expectation is a point such that the government has no incentive to cheat (the point C). This dynamic inconsistency in government plans (due to the incentive to cheat) validates expectations and leads to the time consistent discretionary equilibrium at point C, despite the fact that the other Nash equilibria (point A) possesses pareto optimality.

This table shows that if the trade union does not expect expansion then the government will maximise its support by expanding (cheating). But if the union does expect expansion then the government may as well expand. Therefore, the point B, above a level of output above the level consistent with full employment, is crucial and inevitable since the only Nash equilibria are A and C. Also since at A the government will always have an incentive to cheat, and take advantage of the unions 'naivety', the union will always expect expansion.

Unions always expecting expansion means that the government's choice will always be between C and D. C is preferable to D so the time consistent discretionary equilibrium is the inevitable result, and crucial for the government to achieve the highest possible support (given the restrictions imposed by 'the game'). If an electoral cycle with uncertainty over the outcome of the elections is imposed, then there can be either positive or negative results due to the effects of electoral cycles on economic policy and business cycles2.

Which of these two general outcomes result depends on the nature of the political business cycle that electoral cycles determine. There are four main models that can be highlighted; the non-partisan opportunistic Nordhaus (1975), and Rogoff and Sibert (1988) models, and the partisan ideological Hibbs (1977) and Alesina (1987) models. According to the Nordhaus opportunistic model governments choose economic policy to maximise pluraity at the next election, creating a bias to the future.

This theory is base on the assumptions of a two party political system with complete policy convergence3, both parties being interested in maximising political profits, the timing of elections is exogenously fixed, voters prefer low unemployment and inflation, voters' choice are based on the economic performance of the incumbent government, the macroeconomic system can be described by an expectation augmented Philips curve, expectations of inflation are formed adaptively, and policy makers can control the level of unemployment by manipulating aggregate demand and monetary policy.