Modern Macroeconomics.pdf

The new classical school 253Figure 5.4Consistent and optimal equilibriummonetary policy game discussed by Kydland and Prescott, the government isthe dominant player. When the government decides on its optimal policy itwill take into account the likely reaction of the ‘followers’ (private agents). Ina Stackelberg game, unless there is a precommitment from the leader withrespect to the announced policy, the optimal policy will be dynamicallyinconsistent because the government can improve its own pay-off by cheating.Since the private sector players understand this, the time-consistentequilibrium will be a ‘Nash’ equilibrium. In such a situation each playercorrectly perceives that they are doing the best they can, given the actions ofthe other players, with the leader relinquishing the dominant role (for a nontechnicaldiscussion of game theory, see Davis, 1983).