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Time Discretion Essay

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Below is an essay on "Time Discretion" from Anti Essays, your source for research papers, essays, and term paper examples.

Discretion might look superior to a fixed policy if households and firms trust their policymakers since discretionary policy is flexible. However, one of the problems with this policy is the time inconsistency. Time-inconsistency describes situations where, with the passing of time, policies that were determined to be optimal yesterday are no longer perceived to be optimal today and are not implemented (Dennis, 2003). If the economic policy is conducted by discretion rather than by rule, time inconsistency is very likely to result and leads to higher inflation rates. Furthermore, time-inconsistency can affect more than just the average rate of inflation that prevails in the economy. In particular, it can influence how policymakers respond to shocks and how resources are allocated through time (McEachern, 2009).
The central bank has the twin goals of trying to keep inflation close to some target level and unemployment close to the natural rate. Suppose that the inflation target is 2%; the optimal monetary policy is to announce that the central bank will set monetary policy such that inflation equals 2% and let the labor market clear at the market-clearing level. But this optimal policy is time-inconsistent and will not be implemented. If workers believe the central bank's policy announcement and negotiate a contract with firms providing for a 2% nominal wage increase, then the central bank's range of options changes. Instead of following through and implementing the announced policy, the central bank can create a little more inflation--an inflation surprise--which lowers workers' real wages, stimulating firms' demand for labor. With the nominal wage rate fixed, the labor market now clears at a lower unemployment rate. Thus, at the cost of slightly higher inflation, the economy reaps the benefit of lower unemployment. Nevertheless, workers soon will realize that the central bank's announcements are not credible, and they will come to expect higher inflation, which...

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