Economics
Time Inconsistency and the Credibility of Central Bank Commitments
Quick fact
The Nobel Prize-winning economist Finn Kydland and Edward Prescott formalized the idea of time inconsistency in 1977, showing that policy rules can lead to better outcomes than discretion in many situations.
Why this is interesting
Imagine promising to be strict with a child, but then giving in when they cry. That's time inconsistency. Why do central banks face the same problem, and how does it make their promises less believable?
Read the full explanation
Understanding Time Inconsistency and the Credibility of Central Bank Commitments
Time inconsistency of central bank commitments works like this: A central bank announces it will keep inflation low to anchor expectations. Once people form low inflation expectations, the bank has an incentive to create surprise inflation to reduce unemployment (as in the Phillips curve) because wages and prices were set based on low inflation. However, rational people anticipate this incentive, so they raise their inflation expectations from the start. The result is that the bank ends up with higher inflation and no real gain in employment—the worst of both worlds. The bank's promise is not credible because, after expectations are set, it has a temptation to renege.
A deeper explanation
The mechanism is rooted in the trade-off between short-run and long-run objectives. In the short run, surprise inflation can lower real wages and boost output. But in the long run, people adjust their expectations, so surprise inflation only leads to higher inflation without a lasting growth boost. Under 'discretion' (acting each period without commitment), the central bank maximizes a social loss function that weights inflation and unemployment, but because it ignores how its current actions shape future expectations, it ends up at an equilibrium with high inflation and unemployment at the natural rate. If it could commit credibly to a low-inflation rule, it could achieve lower inflation without sacrificing much. The key is that a mere promise is not enough—something must make the commitment credible. This is why many central banks adopt inflation targets, publish forecasts, and, crucially, are independent from political pressure. Independence reduces the incentive to exploit short-run trade-offs, and repeated interactions build reputation: if a bank breaks a promise once, it loses credibility for the future, so it has incentive to keep its word. This is modeled in the Barro-Gordon model, which shows that reputational forces can partially solve the problem, but institutional commitment mechanisms are more robust.