the boy who cried wolf: the time-inconsistency problem and the Barro-Gordon model

in one of my classes-I came across this interesting idea: the time-inconsistency problem.
this basically departs from the idea that the government plays "games" with private agents (the textbook actually clarifies that by game it doesn't mean "entertainment" but concessions and ruseful tactics employed to achieve what one wants LOL) and that once it loses its credibilty, the outcomes could be desastrous-in others words: don't play games, baby~! :)


Here, we develop an a reputational equilibrium by using Philips Curve which means that only unexpected inflation affects the unemployment rate.


so .... this is what happens: suppose the gov't's wanting to decrease u and ㅠ at the same time  (yes, ㅠ=pie) as it is its goal.


Model (Draw a Graph with vertical axis ∏ and horizontal axis U)

In economic terms, it is said that zero inflation policy is time-inconsistent;


if the gov't announces the infla rate to be 0, and ppl believe: point A
•Clearly the government can do better than point A.

ØIt could cheat and increase the rate of inflation unexpectedly.

•This brings the economy to point B, which is on a higher indifference curve.

ØThe government has an incentive to break its promise to maintain a zero inflation rate.

•This, however, will trigger a shift of the Phillips curve upwards π e = π1. 

•Given this new expectation, it is optimal for the gov’t to move to point C.

•This will shift the Phillips curve upwards again and the process goes on until point E is reached.

--> Authorities face the problem each period that a better short term outcome is possible. Given the repeated interaction between the policymaker and the private agents, it is possible that reputational forces can substitute for formal rules. The economic agent will therefore adjust their inflationary expectations up to the point where the authorities have no incentive to cheat any more.

...

so this is a good ex why ppl have to maintain good reputation and credibility, which are really important instruments you wanna use in a DISCRETIONARY way (this word does NOT only apply to gov't but to ordinary ppl as well, I think)

as I am a European-area studies major, have to think of the Implications to EMU...

in the same way as infation rate announcements, Exchange rate instrument can be a very dangerous one if it is frequently used because of expectation effects.

A systematic use of exchange rate instrument might lead to more price variability. That is, loss of the exchange rate instrument is likely to be less costly for open markets. in the European case, only a full monetary union such as adopting a single currency can establish the required credibility. For reasons above, as a result, discussion for a full monetary union was held by the signing of the Maastricht Treaty, known for the treaty on monetary union.

Implications for life:

Trust and sincerity are really important factors that we have to take in seriously. Many choose to push and shove them aside as secondary for the short-term (potential) gains they see ahead. However, this gains are not true gains and successs built on these gains is not true success but like a house built on sand, for we do not know when it will crumble.