On optimality and time consistency when expectations are rational

This paper explores the implications of time inconsistency for optimal economic policy-making. It is found that if policy-makers determine policy on the assumption that expectations are adaptive when in fact they are rational economic policy can be destabilising. This adds support to reservations which Kydland and Prescott (1977) have raised about the appropriateness of standard optimal control methods. A method is proposed which is a modification of standard optimal control techniques and which allows for the endogeneity of expectations. When this method is used to determine policy there is no indication that policy is destabilising.