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I am reading through a bit of policy literature and see authors referring often to the problem of time inconsistency when setting monetary policy.

Can anyone explain what is time inconsistency?

An example from Daniels and Vanhoose (1998):

Rogoff’s paper makes one of the most fundamental points about policy coordination: In the presence of time inconsistencies, monetary policy coordination is not necessarily welfare improving.

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In a nutshell, time inconsistency occurs whenever a policy maker can publicly commit to a certain policy action in a non-binding way. This is an issue in several settings (commitment vs. discretion settings and, as you see, policy coordination settings). You've run across the issue of time inconsistency in the context of policy coordination across interdependent economies. One can summarize the issue as follows: I promise in $t-1$ to deliver policy action A in period $t$ but instead deliver policy action B once we arrive in period $t$.

Consider, as does the paper you cite here, a simple two-country model where the policy actions in a domestic country impact the loss function of the foreign economy and vice versa. Under certain first order conditions (laid out in the very paper you quote) there are obvious gains available to the policy makers of these nations if they are able to arrive at a coordinated equilibrium rather than the Nash equilibrium. However, in a dynamic game with no commitment device aside from reputational concerns it might be the case that one country will promise to play the coordinated equilibrium and then deviate unilaterally to the cheater equilibrium. As you can see, time inconsistency in this context means (literally) for one to be inconsistent over time with promised and realized policy actions.

Further, see Luchonacho's references in his comment. Both links are quite helpful here and themselves could serve as an answer to your question.

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  • $\begingroup$ You cracked it. I am amazed that this question did not arise before. $\endgroup$ – luchonacho Sep 7 '17 at 17:51

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