Cambridge-INET Working Papers - Abstracts | The Cambridge-INET Institute

Time-Consistently Undominated Policies

WP Number: 1802

Abstract: This paper proposes and characterises a new normative solution concept for Kydland and Prescott problems, allowing for a commitment device. A policy choice is dominated if either (a) an alternative exists that is superior to it in a time-consistent subdomain of the constraint set, or (b) an alternative exists that Paretodominates it over time. Policies may be time-consistently undominated where time-consistent optimality is not possible. We derive necessary and sufficient conditions for this to be true, and show that these are equivalent to a straightforward but significant change to the first-order conditions that apply under Ramsey policy. Time-consistently undominated policies are an order of magnitude simpler than Ramsey choice, whilst retaining normative appeal. This is illustrated across a range of examples.

Keywords: Time Consistency, Undominated Policy, Ramsey Policy

JEL Codes: D02 E61