Implementing the Commitment Solution via Discretionary Policy-Making

33 Pages Posted: 31 Mar 2020 Last revised: 23 Jan 2021

Date Written: January 23, 2021

Abstract

This paper demonstrates that, in a large class of linear-quadratic models with rational expectations, losses due to time-inconsistency problems can be avoided, as the commitment solution can be implemented by a policy-maker who acts under discretion. We focus on two approaches. First, we show that a reputational equilibrium that implements the commitment solution always exists. In this non-Markovian equilibrium, it is optimal for the discretionary policy-maker to react to additional state variables that do not enter the social loss function directly. Second, we show how delegation to a policy-maker with an additional objective for the policy instrument can be used to implement the commitment solution via a standard discretionary Markov equilibrium. This approach can be implemented in practice by using incentive contracts or the announcement of a specific strategy.

Keywords: Discretion, Commitment, LQ RE models, Reputation, Time-Inconsistency, Optimal Delegation

JEL Classification: C61, E52, E61

Suggested Citation

Hahn, Volker, Implementing the Commitment Solution via Discretionary Policy-Making (January 23, 2021). Available at SSRN: https://ssrn.com/abstract=3549448 or http://dx.doi.org/10.2139/ssrn.3549448

Volker Hahn (Contact Author)

University of Konstanz ( email )

Box 143
Konstanz, 78457
Germany

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