Time inconsistency Free Essay Example, 1500 words

They also assumed that markets are devoid of frictions, so that any equilibrium is Pareto optimal. This facilitated matters in the sense that standard welfare theorems allowed them to find and characterize the equilibrium using optimization theory. Since equilibrium delivered the best possible outcome for the representative consumer, they could sidestep the price mechanism and find the equilibrium quantities directly by solving a â€Å"social planning problem†. Based on these quantities, the equilibrium prices were then easily retrieved from the first order conditions for utility and profit maximization. In spite of these drastic simplifications, Kydland and Prescott found it necessary to use numerical analysis to characterize the equilibrium. In so doing, they adapted available insights in numerical analysis to the problem at hand and used computer-aided model solution. Today’s arts of the business cycle models are significantly more complex than that analyzed by Kydland and Prescott. Comparison of the model to data was another challenging task. A standard economical approach, to choose the model’s parameters to obtain the best possible fit to the business cycle data which may not used due to the model complexity and it may leads generate model output for even one set of parameter values was quite tricky and time-consuming. We will write a custom essay sample on Time inconsistency or any topic specifically for you Only $17.96 $11.86/pageorder now For overview, see Amman, Kendrick, and Rust (1996). A numerical solution of a dynamic, stochastic optimization problem is not easy. For doing that Kydland and Prescott adopted the method of â€Å"calibration†. Calibration is a simple form of estimation, since the model parameters are chosen in a well-specified algorithm to fit a division of the overall data. The estimation is based on microeconomic and (long-run) macroeconomic data in practical way (Snowdon & Vane, 2005). It allowed parameterization without solving the full model but allows make any changes when necessary. Time inconsistency model and inflation bias The major stepping stone in this aspect of research is to be found in Kydland and Prescott (1977). By making use of the conceptual insights of earlier methodological contributions, the concept of rational expectations initiated by Lucas (? ) and the more instinctive normative arguments of Friedman and Simon favoring simple rules, this paper reaches some astonishing but logically forceful and very general conclusions. In a general dynamic setting, optimal policy regulations are not likely, because they are ‘‘time inconsistent’’: if the policy rule is believed and used to form expectations of future policy by private agents, the government has an enticement to depart away from it later on, inducing policy ‘‘surprises’’ (Hall, 1983).