Economics
Time Inconsistency in Government Inflation Policy
Quick fact
The theory of time inconsistency was co-developed by Finn Kydland and Edward Prescott, who won the 2004 Nobel Prize in Economics for this and other contributions to business cycle theory.
Why this is interesting
Imagine you promise yourself you'll study tomorrow, but when tomorrow comes, you procrastinate—and then wonder why you never get ahead. Governments face the same kind of temptation with inflation, and it affects your wallet.
Read the full explanation
Understanding Time Inconsistency in Government Inflation Policy
Think of a government that wants to boost employment. It can do so by creating a little surprise inflation, which makes real wages effectively lower and encourages firms to hire more. However, people are not naïve: they know this temptation. So, before the government acts, workers and firms form expectations of inflation. If they expect high inflation, they demand higher wages and set higher prices. The government, wanting to avoid the costs of high inflation, has an incentive to promise low inflation. But once people have set their contracts based on that low-inflation expectation, the government is tempted to break its promise and produce surprise inflation to reduce unemployment temporarily. Why? Because surprise inflation lowers real wages, making labor cheaper and stimulating the economy. This is the time inconsistency: the policy that is optimal at the moment of implementation (surprise inflation) is inconsistent with the policy that was optimal when announced (low inflation). In other words, the government's incentives change over time, even if nothing else changes. The result is that, if the government is free to choose every period, its announcements are not credible, and people will expect inflation anyway. Then we get inflation without any employment benefit—the worst of both worlds.
A deeper explanation
The mechanism is rooted in the interaction between expectations and policy incentives. In a simple model, society has a preferred level of output (above the natural rate), and the government dislikes both inflation and unemployment. Without commitment, the government will choose inflation that minimizes its loss given current expectations. But because expectations are rational, they will factor in the government's incentive to inflate. So, the equilibrium ends up with higher inflation than if the government could credibly commit to low inflation, but no higher output. This is a classic time inconsistency problem. The core insight is that policy rules that bind future decisions can be better than discretionary choice, because they remove the temptation to deviate. This led to the idea of delegating monetary policy to an independent central bank with a clear mandate, and to inflation targeting regimes. These institutional solutions increase credibility by making it costly for policymakers to break promises. Without such institutions, the temptation to inflate remains, and expectations adjust, leading to inefficiency. Understanding this concept changes how we view policy announcements: they are only effective if backed by institutions that make breaking them costly.