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B. Venkatesh

THE 2004 Nobel Prize for Economics has been awarded to Professors Finn Kydland and Edward Prescott for their study on business cycles and time-consistent economic policy. What is time-consistent economic policy?

Suppose a government states that the marginal tax rate on income will be reduced from 30 per cent to 10 per cent and that this tax rate will be applicable for the next 10 years. This will prompt you and many others to spend more. Why?

Your disposable income will increase because of lower taxes. Besides, you do not have to save more today to meet your future expenditure.

But what if the government were to change its policy on taxes two years hence? You will feel bitter, having consumed more in earlier years and saved less then.

Importantly, you will begin to distrust the government. And that could have a bearing on the fiscal and monetary policy. How?

Assume that the government states that it wants to lower inflation in the next five years. If people trust the government, they will take economic decisions that will reflect their belief that the inflation will, indeed, be low in the coming years.

Because of such economic decisions, inflation will be low. This could prompt the government to abandon its lower inflation policy after sometime. This is called the time-consistent problem because policy-making is not consistent over time.

Professors Kydland and Prescott argued that any long-term decision announced by such a government would have little credibility. To overcome this problem, they suggested that the monetary and fiscal policy should be conducted based on long-run rules.

Based on their study, several central banks have well-defined inflation targeting rules. The Reserve Bank of New Zealand, for instance, has an inflation target of 1-3 per cent.

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