Discretion Rather Than Rules: Ramsey Policy as the Unique Outcome

Chihiro Morooka

doi:10.4236/tel.2020.106071

Abstract

This paper analyzes finitely repeated policy games where the government and the private sector alternately revise their actions from the set of non-negative real numbers. Unlike previous studies on policy games, the one-shot inefficient Nash equilibrium, known as the Kydland-Prescott outcome, is avoided and only the optimal Ramsey outcome is established in subgame perfect equilibria. Therefore, the Ramsey policy is time-consistent in our model, whereas the Kydland-Prescott outcome is not.

Highlights

In macroeconomic theory, the fundamental problem of implementing the optimal policy arises when the government does not have credible technology of commitment, and the private sector has rational expectations about the government’s policy
Unlike previous studies on policy games, the one-shot inefficient Nash equilibrium, known as the Kydland-Prescott outcome, is avoided and only the optimal Ramsey outcome is established in subgame perfect equilibria
It is known that only one inefficient Nash equilibrium exists, known as the Kydland-Prescott (KP) outcome, because the government has a dominant myopic action, leading to the private sector’s inefficient response

Summary

Introduction

The fundamental problem of implementing the optimal policy arises when the government does not have credible technology of commitment, and the private sector has rational expectations about the government’s policy. It is known that only one inefficient Nash equilibrium exists, known as the Kydland-Prescott (KP) outcome, because the government has a dominant myopic action, leading to the private sector’s inefficient response. This outcome is Pareto-dominated by the Ramsey outcome, which maximizes the government’s objective function by behaving as the Stackelberg leader. Avoiding the KP outcome requires a long-run trustful relationship, which is often modeled by repeated games Previous research in this field includes Chari and Kehoe (1990) and Stokey (1991).

Morooka DOI

Policy Games

Discussion and Conclusion