Credibility and Commitment in Economic Policy

David Backus and Edward Driffill ()

Working Paper from Economics Department, Queen's University

Abstract: Dynamic inconsistency provides a theoretical basis for discussions of policy credibility: when the government cannot commit its future policies, the incentive to deviate from the 'optimal' plan renders it incredible. We derive the best policy in the absence of precommitment as the feedback Nash solution to a dynamic game between the government and the private sector. This solution is dynamically consistent by construction, and therefore credible. An application to disinflation shows that the feedback Nash policy may be considerably more costly than the 'optimal', but inconsistent policy.

Pages: 22 pages
Date: 1985
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Working Paper: Credibility and Commitment in Economic Policy (1985)
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