By Minseong Kim
We demonstrate that if all agents in an economy make time-consistent decisions and policies, then there exists no rational expectation equilibrium in a dynamic stochastic general equilibrium (DSGE) model, unless under very restrictive and special circumstances. Some time-consistent interest rate rules, such as Taylor rule, worsen the equilibrium non-existence issue in general circumstances. Monetary policy needs to be lagged in order to avoid equilibrium non-existence due to agents making time-consistent decisions. We also show that due to the transversality condition issue, either fiscal-monetary coordination may need to be modeled, or it may be necessary to write a model such that bonds or money provides utility as medium of exchange or has liquidity roles.
This is one of those rare papers where you start thinking: “Really? How has everybody missed this for so long?” This seems to be a quite fundamental issue and I am eager to see how others react to it.