Credibility and Commitment in Economic Policy

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.