Credibility Concerns in Optimal Policy Design

Abstract

This paper models credibility management by a government using a simple reputation game in which government type is not directly observable by the private sector. Two non-standard features of the game produce conditions under which it is optimal for a trustworthy type (able to pre-commit) to separate itself from an opportunistic type (unable to pre-commit). First, policy announcement is introduced as an instrument, in addition to policy action, so that not only the opportunistic but also the trustworthy type behaves strategically. Second, time preference can differ across types. The combination of a patient trustworthy type and an impatient opportunistic type thus leads to early stages of the game marked by active policymaking (announcements and actions) on the part of the government and rapid learning on the part of the private sector, a result absent in the literature but more in line with reality.

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