Kydland and Prescott’s intertemporal inconsistency claim
One of Friedman’s claims in his Presidential Address was that agents could not be fooled on a recurrent basis. In an influential article, Finn Kydland and Edward Prescott (1977) re-expressed this idea in a more rigorous way by building their argumentation on the rational expectations hypothesis.
This article became an important element in the rules versus discretion debate, on the “rules” side. At stake was the issue of governments’ policy declarations of intention. Kydland and Prescott’s bold claim was that a benevolent well-informed government would repeatedly repudiate its promises unless it was constitutionally impeded from doing so. A standard example is that of a government aiming to boost investment and so announcing that an increase in the interest rate was going to occur in a year’s time, thereby triggering firms to hasten their investment plans. The snag is that a year later it may well turn out that it is in the government’s interest to forgo this increase because of its deflationary effects. However, if it does so, its credibility will be harmed, and its future announcements may no longer be taken seriously.Kydland and Prescott’s credibility argument was scarcely original - earlier versions can be found in the writings of dynamic games theorists - but they introduced it into the macroeconomic debate. Its implication is a drastic narrowing of governmental discretion. In effect, once the credibility dimension is taken on board, policy announcements will be deemed credible by private agents only if they can be sure that, when the proper time arises, the government will have a firm interest in (or no way out of) implementing the policy.