Summary: In economics, dynamic inconsistency, or time inconsistency, describes a situation where a decision-maker’s preferences change over time in such a way that what is preferred at one point in time is inconsistent with what is preferred at another point in time. It is often easiest to think about preferences over time in this context by thinking of decision-makers as being made up of many different “selves”, with each self representing the decision-maker at a different point in time. So, for example, there is my today self, my tomorrow self, my next Tuesday self, my year from now self, etc. The inconsistency will occur when somehow the preferences of some of the selves are not aligned with each other.

One type of inconsistency is more closely affiliated with game theory, and “dynamic inconsistency” is the more commonly used terminology in this case. Another type of inconsistency is more closely affiliated with behavioral economics, and “time inconsistency” is the more commonly used terminology there.

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The Time Consistency Problem

This paper is an introduction to the discussion about the time inconsistency of optimal policy, which arises in many dynamic problems if rational expectations are assumed.1 The structure of this paper is as follows: First I introduce the general problem of time inconsistency mainly based on the arguments of Kydland and Prescott (1977). Since this paper concentrates on monetary models, I then give an overview on the relevant literature. In the monetary context I explain the Barro and Gordon setup under perfect information as a single and also as a repeated game with two different reputation mechanisms.

Further on I make use of the Backus and Driffill model to explain how the time inconsistency may not arise under asymmetric information about the policymaker’s preferences. The models of Cukierman and Liviatan (1991) and Cukierman (2000a) show that time inconsistency arises for private information about the policymaker’s ability to precommit and to control inflation. Furthermore there may be asymmetric information about economic shocks or, as shown in this paper, with a timing where the public has to built expectations about the shock prior to its realization and the policymaker’s reaction to it. In this situation a fix policy rule is welfare-inferior to a flexible rule policy, which in addition is time consistent even for high uncertainty. Finally I give a short comment on the empirical evidence for some of the models.

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