Kydland and Prescott

Page 104 (Drazen)

The Representative Agent does not internalize the government’s budget constraint and assumes his choices have no impact on economy-wide aggregates (in contrast, a single individual would internalize the government's budget constraint).

Given the individual’s decision, the government chooses T(k) and T(l) in order to maximize the individuals welfare subject to the government’s budget constraint.

Ranked Outcomes:

  • Command Optimum
    • Government has the power to command the optimum allocation.
  • Time inconsistent solution
    • A government maximizing welfare has the incentive to be time-inconsistent, announcing low rates of labor taxation ex-ante and then after capital is accumulated tax it heavier, as well as have a surprise capital levy. Ex-post capital is an inelastically supplied input. Time-inconsistency will characterize factor taxation whenever the ex-post elasticity of factor supply is less than the ex-ante elasticity. Time-inconsistent solution is not called a equilibrium because it does not work on rational forward looking people.
  • Pre-commitment Solution
    • Government commits to a solution and can promise not to re-optimize in the second period.
  • Time-Consistent
    • When people in the model are forward looking and rational, they will realize government has the incentive to tax more in the second period and adjust period one behavior according, this is called the dynamic programming solution

Reasons for Time-Inconsistency:

  • Insufficient Instruments
  • Lower ex-post than ex-ante elasticity
  • People react rationally to pre-existing constraints and distortions.
  • Sequential nature of policy making and the possibility to deviate from earlier plans and policies
  • Conflict of interest i.e. ex-post heterogeneity (Drazen stresses this one)