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Part - IV

A simpler example is that of mothers who threaten to punish their children in order to produce certain kind of behaviour. This situation often displays the time-inconsistency problem. The child figures out that the mother does not want to punish and hence the mother is not able to achieve what she wanted to.

So, individuals are better-off when the central bank's intentions are consistent and credible. If the central bank has the discretion to change its decisions frequently, then there will be more uncertainty regarding unemployment, inflation, interest rates, wages, etc.

This research by Prescott and Kydland had led to a focus on how central banks can be strengthened and made more independent in order to minimize the time-inconsistency problem. Many central banks around the world have focused on long-term objectives of seeking low inflation. The United States, for example, has an implicit policy of pursuing low inflation. Since the early 90s, many countries, including, United Kingdom, New Zealand and Sweden have followed a policy of inflation targeting. Many of these changes by central banks are the result of the work done by Prescott and Kydland in this area.

Supply-Side Realities

Another paper by Prescott and Kydland, "Time to Build and Aggregate Fluctuations", turned Keynesian economics upside down by finding that business cycles were the result of shocks to the aggregate supply than to the aggregate demand.

One of the basic prepositions of Keynesian thought is that a well-functioning economy should not have any business cycles. The presence of cycles was the result of the malfunctioning of the economy and needed to be fixed.

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* Contributed by -
Ravi Birhman, B.E. (Computer Science), BITS, Pilani,
Kshitij Goel, B.Tech. (Mechanical), IIT Guwahati,
Post Graduate Diploma in Management (First Year),
Indian Institute of Management, Calcutta.