OPTIMAL PRE-COMMITMENT IN MACROECONOMIC POLICY: A GAME THEORETIC ANALYSIS OF FISCAL POLICY

Abstract

The version of the paper published in Oxford Economic Papers (Volume 42, October 1990, pp. 695–714) erroneously omitted the figures. This note presents the figures and briefly describes the results they show. The paper proposed a new solution to the problem of time inconsistency. A subgame-perfect trigger strategy equilibrium was presented in which the public expected the government to renege on its originally announced policy at some later date. The government's pre-commitment to its announced policy was determined endogenously as part of the equilibrium. The equilibrium was illustrated using Blanchard's (1985) model of fiscal policy. I examined the [political] problem of maintaining aggregate consumption while reducing the level of government debt. The problem of time inconsistency arises in this context because the government has an incentive to renege on its promise to raise future taxes. Numerical solutions of the model showed that the government would renege after a period that depended on its expected tenure and preferences. Figures 1 to 4 show the behavior of the economy under policies with no pre-commitment ([ t0t* ) = 0), a moderate period of precommitment ([ t0t* ) = 33.5), and a long period of pre-commitment ([ t0t* ) = 140.2). Figure 1 shows that governments with greater credibility will prefer to push the costs of falling consumption further into the future. This is achieved by adopting policies that promise to raise future revenues while cutting current taxes so that the fall in the value of government debt is offset by the rise in human wealth [see Figures 2 and 4]. One important consequence of these policies is that the level of government debt rises during much of the period of pre-commitment. Figure 5 is used in the appendix to prove proposition 1