Dynamic Inconsistency of Low-Inflation Monetary Research Paper

  • Length: 11 pages
  • Subject: Economics
  • Type: Research Paper
  • Paper: #91278245

Excerpt from Research Paper :

9 trillion in treasuries to move unemployment down to 6.5%" (5). These outcomes make it abundantly clear that the national economy is not particularly responsive to short-term stop-gap measures that do not take the long-term needs for economic growth and stability into account. The trillions of dollars invested in stimulus packages to date have produced the responses in unemployment levels illustrated in Figure 1 below.

Figure 1. Unemployment levels in the United States: 2007-2010

Source: Bureau of Labor Statistics 2011 at http://www.bls.gov/

As can be readily discerned from Figure 1 above, the very slight decrease in the unemployment rate experience over the last 12 months has cost American taxpayers far more than the economic benefits that are associated with such modest reductions. Unfortunately, there does not appear to be a solution on the horizon at this point in time. For example, according to a recent press release (May 2011) from the Bureau of Labor Statistics, the consumer price index for all items less food and energy increased 0.3% in May 2011, the largest increase experienced since July 2008. In addition, there also increases experienced in the apparel, shelter, new vehicles, and recreation categories, but there were some modest decreases in the gasoline index (Consumer Price Index 1). These fairly significant increases are illustrated graphically in Figure 2 below.

Figure 2. 12-month percent change in CPI for All Urban Consumers (CPI-U), not seasonally adjusted, May 2010 - May 2011

Source: Consumer Price Index 1

Taken together, these economic stimulus initiatives have produced some short-term but modest improvements in various economic indicators in ways that are reflective of the issues that are typically associated with the dynamic-inconsistency problem which is discussed further below.

The Dynamic-Inconsistency Problem

According to Connolly, a dynamic-inconsistency problem exists "when a preferred course of action, once undertaken, cannot be adhered to without the establishment of some commitment mechanism" (1579). In the context of the national economy, the dynamic-inconsistency problem describes the tendency for policymakers to engage in popular short-term solutions rather than taking the more difficult steps needed to ensure long-term economic growth. For example, according to Goodman:

Creating an independent central bank can be seen as a way for governments to prevent themselves (and their successors) from pursuing overly expansionary policies. Central bank independence is thus considered a solution to what economists term the dynamic inconsistency of policy. Dynamic inconsistency refers to the inability of politicians to commit to and implement policies that may be best for the economy in the long run, but are politically harmful in the short run. (6)

In reality, this definition should be qualified somewhat by noting that such behaviors by politicians may be attributable more to an unwillingness to act rather than an inability, but the bottom-line effect on the economy remains essentially the same. For example, Haubrich reports that, "Economists refer to the tendency to yield to temptations that undermine a desired goal as the dynamic inconsistency problem. The long-term plan (that's the dynamic part) is inconsistent because what looks best in the short run, when the choice is made, does not add up to what is best in the long run" (2). In the case of central banks, the temptation exists to exploit the so-called inflation-output trade-off in order to achieve politically popular short-term goals -- but the actual effect of such policies can be far from what is expected or desires. In this regard, Haubrich adds that, "Because unexpected inflation has been noted to boost output, even a central bank with a desire to keep inflation low may attempt to cause a bit of it to help bring down a high unemployment rate. So it increases the money supply. The public, however, almost always anticipates this tendency, so far from being unexpected, the inflation caused by the central bank is quite expected, and unemployment doesn't fall" (2).

With respect to analyzing the dynamic inconsistency of low-inflation monetary policy, Jha reports that, "The basic intuition behind the analysis is quite straightforward. Type I policymakers have the same social welfare function as the public's. In cases where consumers are uncertain concerning what type of central banker they have, the lower the inflation they observe the more they are convinced that they have a Type I central banker" (330). When policymakers have essentially the same social welfare interests as the public, then, there will be a tendency to pursue longer-term economic policies that may not be politically popular in the short-term. In this regard, Jha adds that, "The greater the emphasis the central banker places on losses from future inflation, the more inclined will he be to pursue low inflation policies today. Thus there are these two approaches to removing the inflationary bias of monetary policy (330).

As noted above, the quantitative easing initiatives have in fact succeeded in achieving some slight reductions in the unemployment rate as well as some other economic indicators, but at a tremendous cost of public treasure. This outcome is reflective of Jha's observation that, "Even when a rules regime is in place, there is always the possibility that the central banker will find it profitable to cheat and opt for positive inflation in order to exploit the inflation-unemployment tradeoff. The public is aware of this temptation facing the central banker. What makes springing such surprises profitable for the central banker? The first factor is that the inflation-unemployment tradeoff can be exploited" (330).

Beyond the foregoing factor, there are other ways that the inflation-unemployment tradeoff can be exploited as well. For instance, Jha adds that, "In the context of developing countries, in particular, there are other motives such as seignorage and lowering the real value of the government debt" (Jha 330). According to Black's Law Dictionary, seignorage is "a royalty or prerogative of the sovereign . . . Mintage, the charge for coining bullion into money at the mint. A sum equivalent to the difference between interest payable upon securities" (1358). Therefore, short-term economic gains can be achieved in a number of ways by manipulating the inflation-unemployment tradeoff in ways that are reflective of the dynamic-inconsistency problem.

The nature of the political beast that is involved in the dynamic-inconsistency problem also ensures that these types of exploitations will continue in the future. Certainly, this is not to say that all policymakers are motivated primarily by self-interest, but it is to say that politicians are engaged in a relentless cycle of seeking reelection and that the politically unpopular and tough choices that are needed for long-term recovery may not be readily forthcoming. In this regard, Leijonhufvud emphasizes that on the one hand, "Admittedly, the tenor of the dynamic inconsistency literature is that the central bank continually faces the temptation to inflate opportunistically and does in some way have to be locked in credibly"; and, on the other hand, "Furthermore, it also seems that the political arm is far from eager to use the means readily available to it to lock in committed behaviour for monetary policy" (9). This point is also made by Eggertson who points out, "The source of the deflation bias is inefficient response to temporary shocks, due to the government's inability to commit, whereas the inflation bias arises even in the absence of shocks. This implies that it may be even harder for a central bank to accrue reputation for fighting deflation than inflation (since the main culprit for deflation is infrequent shocks)" (284).

This reluctance to commit is understandable, if not justifiable, from the dynamic-inconsistency perspective, and it is reasonable to suggest that policymakers are able to rationalize short-term initiatives that are politically popular because of their need to remain in office in order to accomplish longer-term improvements. This spurious reasoning, though, only serves to perpetuate the dynamic-inconsistency problem in ways that confound even the most well-intention policymakers from effecting the substantive changes that are required for long-term economic stability and growth because of the political fallout that would likely result.


The research showed that in response to the Great Recession of 2008, the Federal Reserve has engaged in a series of economic stimulus packages that have resulted in some modest short-term improvements in some economic indicators, including the unemployment rate. These improvements have been loudly cited by the Obama administration as proof positive that the enormously expensive economic stimulus packages are working, but critics suggest that American taxpayers are not receiving a sufficient "bang for their buck" in terms of the actual effects of these efforts compared to their costs. The research also showed that the dynamic inconsistency of low-inflation monetary policies plays out in real-world settings when sustaining economic growth and reducing unemployment are overarching goals.

Works Cited

Black's Law Dictionary. St. Paul, MN: West Publishing Co., 1999.

Connolly, Kelley. (2007). "Say What You Mean: Improved Drafting Resources as a Means for Increasing the Consistency of Interpretation of Bilateral Investment Treaties." Vanderbilt

Journal of Transnational Law 40(5): 1579-1582.

"Consumer Price Index." (2011, May). Bureau of Labor Statistics. [Online] available: http://


Draper, Heather. (2011, June 14). "So did…

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