Time Inconsistency

The concept and Kydland–Prescott

Time (or dynamic) inconsistency was formalized as a central problem of macroeconomic policy by Finn Kydland and Edward Prescott in their 1977 paper "Rules Rather than Discretion," work that contributed to their 2004 Nobel Prize. The key point is that if people form rational expectations about future policy and act on them now, a policy plan that is optimal today is no longer optimal once people have committed their actions. If a government promises not to tax capital in order to encourage investment, firms invest, but once factories are built capital cannot move, so the government is tempted to tax it. Anticipating this, firms invest less from the start. Patents, building restrictions in disaster zones and a teacher's promise of "no extensions this time" have the same structure. Together with the Lucas critique, this changed how policy is evaluated.

Monetary policy and inflation bias

The best-known application is monetary policy. With an expectations-augmented Phillips curve, a central bank facing low expected inflation is tempted to create surprise inflation to reduce unemployment. If people know this, they expect high inflation, and the result is an "inflation bias": higher inflation with no gain in unemployment. Barro and Gordon (1983) analyzed this with game-theoretic models and showed that in repeated games a central bank's reputation can sustain commitment. Proposed solutions include fixed rules, appointing a "conservative central banker" more averse to inflation (Rogoff, 1985), performance contracts (Walsh, 1995) and inflation targeting (Svensson, 1997). Alesina and Summers (1993) presented evidence that countries with more independent central banks had lower inflation without sacrificing growth. Fischer (1980) showed the problem arises even for a government acting in citizens' interests.

Individual choice and behavioral economics

Time inconsistency also appears at the individual level. Robert Strotz (1955) showed that if a person's discount rate is not constant, future selves will overturn plans made today. David Laibson (1997) explained undersaving with a (quasi-)hyperbolic discounting model that heavily discounts the near future, and O'Donoghue and Rabin (1999) compared procrastination by "sophisticated" people aware of their future bias with "naive" ones who are not. With bounded rationality, this became a core theme of behavioral economics. The remedy is a commitment device that binds oneself, like Odysseus tied to the mast. Ashraf, Karlan and Yin (2006) found that a savings product in the Philippines restricting withdrawals until a set date raised saving, and Thaler and Benartzi's (2004) Save More Tomorrow program, which pre-commits future raises to saving, sharply increased saving rates. Along with the policy-ineffectiveness proposition, the concept shows how expectations and credibility shape policy outcomes.

FAQ

What is time inconsistency in simple terms?

It is when a plan promised as best today looks worse than another option when the time comes, creating a temptation to break the promise; if others anticipate this, they do not believe the promise in the first place.

How is the time-inconsistency problem solved?

In policy, through fixed rules, independent central banks, inflation targeting and reputation; for individuals, through commitment devices such as withdrawal-restricted or automatic savings.

Sources reviewed: 2026-10-26

References

1. Kydland, F. E., & Prescott, E. C. (1977). Rules rather than discretion: The inconsistency of optimal plans. Journal of Political Economy, 85(3), 473–491.
2. Strotz, R. H. (1955). Myopia and inconsistency in dynamic utility maximization. Review of Economic Studies, 23(3), 165–180.
3. Barro, R. J., & Gordon, D. B. (1983). A positive theory of monetary policy in a natural rate model. Journal of Political Economy, 91(4), 589–610.
4. Barro, R. J., & Gordon, D. B. (1983). Rules, discretion and reputation in a model of monetary policy. Journal of Monetary Economics, 12(1), 101–121.
5. Rogoff, K. (1985). The optimal degree of commitment to an intermediate monetary target. Quarterly Journal of Economics, 100(4), 1169–1189.
6. Walsh, C. E. (1995). Optimal contracts for central bankers. American Economic Review, 85(1), 150–167.
7. Laibson, D. (1997). Golden eggs and hyperbolic discounting. Quarterly Journal of Economics, 112(2), 443–477.
8. O'Donoghue, T., & Rabin, M. (1999). Doing it now or later. American Economic Review, 89(1), 103–124.
9. Alesina, A., & Summers, L. H. (1993). Central bank independence and macroeconomic performance: Some comparative evidence. Journal of Money, Credit and Banking, 25(2), 151–162.
10. Fischer, S. (1980). Dynamic inconsistency, cooperation and the benevolent dissembling government. Journal of Economic Dynamics and Control, 2, 93–107.
11. Thaler, R. H., & Benartzi, S. (2004). Save More Tomorrow: Using behavioral economics to increase employee saving. Journal of Political Economy, 112(S1), S164–S187.
12. Ashraf, N., Karlan, D., & Yin, W. (2006). Tying Odysseus to the mast: Evidence from a commitment savings product in the Philippines. Quarterly Journal of Economics, 121(2), 635–672.
13. Svensson, L. E. O. (1997). Optimal inflation targets, 'conservative' central banks, and linear inflation contracts. American Economic Review, 87(1), 98–114.