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Part - II

The Problem of Time-Inconsistency

In their 1977 paper, "Rules Rather Than Discretion", Prescott and Kydland made it clear that monetary policy decisions are often time-inconsistent. This means that monetary policy decisions to tackle immediate problems such as unemployment will often have fallouts which would reduce the incentive for the monetary policy change. When a government announces a solution to a short-term problem, the expectations of individuals and companies change. These manifest themselves in new decisions on their part. These decisions, in turn, have a feeding effect on the overall economic scenario reducing the incentive for the policy change. Thus, if a government has the discretion to pursue any policy it wants and cannot remain committed to its promises, it will face what Prescott and Kydland called a "Credibility Problem". To counter this problem, it is advisable for a central bank to focus on long-term goals and not interfere in the economy too aggressively in the short-run. The paper made it clear that a central bank needs to be consistent with its monetary policy over time as opposed to thinking what's optimal right now.

As an example, consider the Japanese economy. After decades of "miracle" economic growth rates since World War II, the Japanese economy abruptly faltered in 1990 and has been on a path of stagnation ever since. After the Plaza Accord of September 1985, the yen appreciated by almost half hitting the Japanese exports hard. The economic growth reduced from 4.4% in 1985 to 2.9% in 1986. The government followed an expansionary monetary policy in order to offset the stronger yen. From January 1986 to February 1987, the Bank of Japan cut the discount rate from 5% to 2.5%. This economic stimulus resulted in the creation of financial bubbles in the real estate and stock markets. The immediate response was a tightening of the monetary policy. The discount rate was increased five times reaching 6% in 1990. The markets collapsed. The Nikkei stock market index fell more than 60% from a high of 40,000 at the end of 1989 to under 15,000 by 1992. Real estate prices also plummeted by 80% from 1991 to 1998. The unemployment rate rose from 2.1% in 1991 to 4.7% at the end of 2000. This rate, although low by international standards, is significant in the context of Japan given the historical precedent of lifetime employment and given that it was never above 2.8% in the 80s.

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* Contributed by -
Ravi Birhman, B.E. (Computer Science), BITS, Pilani,
Kshitij Goel, B.Tech. (Mechanical), IIT Guwahati,
Post Graduate Diploma in Management (First Year),
Indian Institute of Management, Calcutta.