What is the Difference Between Monetary Policy and Fiscal Policy?

Time inconsistency refers to the action plan planned for period t + i, and when t + i arrives, the implementation of this action plan is no longer optimal. The basic idea of time inconsistency proposed by Kidland and Prescott can be illustrated by a simple two-period model. In period t, the government decides on the policies it will take in period t + 1 to maximize the welfare of the entire society. Social welfare at t + 1 period depends not only on the actual policies adopted by the government during t + 1 period, but also on the savings, wages and other decisions made by the private sector during t period. The private sector's decision at period t depends on its expectations of the policies actually adopted by the government in period t + 1. It is assumed here that there is no uncertainty. The private sector participants are rational economic people who can fully foresee the policies that the government will adopt in t + 1. ^[1]

Time inconsistencies in monetary policy

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Time inconsistency refers to the action plan planned for period t + i, and when t + i arrives, the implementation of this action plan is no longer optimal. The basic idea of time inconsistency proposed by Kidland and Prescott can be illustrated by a simple two-period model. In period t, the government decides on the policies it will take in period t + 1 to maximize the welfare of the entire society. Social welfare at t + 1 period depends not only on the actual policies adopted by the government during t + 1 period, but also on the savings, wages and other decisions made by the private sector during t period. The private sector's decision at period t depends on its expectations of the policies actually adopted by the government in period t + 1. It is assumed here that there is no uncertainty. The private sector participants are rational economic people who can fully foresee the policies that the government will adopt in t + 1. ^[1]

Time inconsistency refers to the action plan planned for period t + i, and when t + i arrives, the implementation of this action plan is no longer optimal. The basic idea of time inconsistency proposed by Kidland and Prescott can be illustrated by a simple two-period model. In period t, the government decides on the policies it will take in period t + 1 to maximize the welfare of the entire society. Social welfare at t + 1 period depends not only on the actual policies adopted by the government during t + 1 period, but also on the savings, wages and other decisions made by the private sector during t period. The private sector's decision at period t depends on its expectations of the policies actually adopted by the government in period t + 1. It is assumed here that there is no uncertainty. The private sector participants are rational economic people who can fully foresee the policies that the government will adopt in t + 1. ^[1]

There are some overly harsh and even unreasonable assumptions in the theoretical analysis of dynamic inconsistencies, which have affected their analysis and application in China. For example, in this theory, it is assumed that the economic environment strictly complies with the Philips curve. At the same time, it also intentionally or unintentionally considers the decentralized private sector as a single unity with a high degree of coordination, and they can make the correct monetary policy of the central bank every time. Rational expectations, this does not seem to be very realistic in our country. In addition, the current formulation of the central bank s monetary policy must fully take into account other social goals such as social stability and ensuring employment. Therefore, even under the condition that short-term benefits can be obtained by adopting a deceptive strategy, the central bank may not necessarily depart from its prior formulation. Monetary policy. However, some studies have shown that China s loose monetary policy has weakened the role of stimulating the economy. There are obvious time inconsistency characteristics in monetary policy, which are mainly manifested in interest rate policies, bank loans, and internal short-circuits in bank funds. Therefore, It is of great significance for us to study and learn from the theory of dynamic inconsistency. ^[1]

Based on Kidland and Prescott (1977), Barro & Cordon (1983a) elaborated on the issue of time inconsistencies in monetary policy. As far as monetary policy is concerned, low inflation is optimal, but low inflation policy is not consistent in time. The existence of income taxes and unemployment subsidies has led to distortions in the labor market, which has caused the natural unemployment rate to be too high, so the government has an incentive to expand employment and increase output. According to the additional expected Phillips curve, the government can only achieve the goal of expanding employment through unexpected inflation. If the public expects the government to implement a low inflation policy, the best decision of the government is to act with discretion and implement higher inflation, that is, the government has a tendency to inflation. Because the public is expecting rationally, they expect the government to take deceptive behaviors. When signing wage contracts, they will take into account the possibility of higher inflation in the future. As a result, the inflation rate at equilibrium is higher, and Output remains at the natural rate level. This also shows that it is better to follow the rules than to make policy decisions. ^[1]

Since Barro & Gordon (1983a), a large amount of literature has studied how to eliminate time inconsistencies in monetary policy. Although there are potential benefits to strictly following statutory rules, there are obvious deficiencies in adopting rules. In order to facilitate implementation in practice, rules must be very simple, making it difficult for policies to respond to unforeseen events. respond. Because acting on simple rules can cause output to fluctuate too much, adopting simple, non-contingent monetary policy rules, such as a fixed exchange rate, may not be as good as the camera. This has prompted researchers to focus on how to improve the effects of selective policy making, and to focus on reducing or eliminating inflationary tendencies caused by time inconsistencies in monetary policy. ^[1]

Since the introduction of dynamic inconsistencies in monetary policy, many scholars have analyzed the various methods that constrain the central bank's choice of monetary policy and reduce the inflation bias caused by dynamic inconsistent monetary policy. One of the methods is to implement the optimal inflation target system. This institutional arrangement is that the government and related agencies determine specific inflation targets for the central bank, and entrust the central bank to implement monetary policy, requiring the central bank to achieve clear inflation targets, and the government does not interfere with the specific operations of the central bank. Past practice shows that when the central bank uses monetary policy, its monetary policy decisions have inflation preferences under the interference of politics and other factors, and it often exchanges economic growth and employment levels at the expense of price stability. With promises, it is difficult for the central bank to control inflation at a lower level for a longer period. Clear inflation targets can strengthen the responsibility and integrity of the central bank, constrain its performance of its commitments, and solve the problem of dynamic and inconsistent monetary policy. To build credibility among the public, the central bank must accept public supervision and evaluation. The public needs to obtain a large amount of sufficient information to evaluate and monitor the central bank's policy behavior, and this is based on the detailed disclosure of central bank policy decision information. ^[1]