Credibilty Concerns in Optimal Policy Design
First version of this paper: November 2008. This paper is based on the first chapter of my doctoral thesis at Boston University. I owe a great debt of gratitude to Robert G. King for his constant guidance and support. The paper also benefits from discussions with Russell Cooper, Martin Cripps, Steve Davis, Piero Gottardi, Veronica Guerrieri, Peter Ireland, Bart Lipman, Lars Stole, and seminar participants at Boston University, Green Line Macro Meeting, UC-Santa Cruz, UChicago-Booth, FRB Richmond, FRB Kansas City, FRB Philidephia, Hong Kong University, Hong Kong University of Science and Technology, Chinese University of Hong Kong, City University of Hong Kong, European University Institute, Toulouse School of Economics and LUISS. All errors are my own. ; This paper provides a transparent framework for thinking about optimal investment in reputation by a trustworthy government. This topic has been neglected by the existing literature on reputation games but is potentially a central issue in actual policymaking. A nonstandard feature of this model is that a "trustworthy" government (able to pre-commit) optimally chooses a policy announcement to which it commits. Thus, investing in reputation can be achieved by announcing policy plans that are costly and in turn are unlikely to be enacted if the government were an "opportunistic" type (unable to precommit). I identify the key trade-off in determining the optimal policy plans, which is mainly influenced by the difference in the time preference across types. When a trustworthy type is sufficiently more patient than an opportunistic type, there will be substantial reputation-building by the trustworthy type in the early stages of the game, which eventually leads to full separation from the opportunistic type.
