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

The version of the paper published in Oxford Economic Papers(Volume 42, October 1990, pp. 695–714) erroneously omittedthe figures. This note presents the figures and briefly describesthe results they show. The paper proposed a new solution to the problem of time inconsistency.A subgame-perfect trigger strategy equilibrium was presentedin which the public expected the government to renege on itsoriginally announced policy at some later date. The government'spre-commitment to its announced policy was determined endogenouslyas part of the equilibrium. The equilibrium was illustrated using Blanchard's (1985) modelof fiscal policy. I examined the political] problem of maintainingaggregate consumption while reducing the level of governmentdebt. The problem of time inconsistency arises in this contextbecause the government has an incentive to renege on its promiseto raise future taxes. Numerical solutions of the model showedthat the government would renege after a period that dependedon its expected tenure and preferences. Figures 1 to 4 showthe 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 willprefer to push the costs of falling consumption further intothe future. This is achieved by adopting policies that promiseto raise future revenues while cutting current taxes so thatthe fall in the value of government debt is offset by the risein human wealth see Figures 2 and 4]. One important consequenceof these policies is that the level of government debt risesduring much of the period of pre-commitment. Figure 5 is used in the appendix to prove proposition 1