2 Pitfalls of discretionary monetary policy Starting in the 1970s, the economics profession began to recognize that the evolution of economic activity and inflation – and hence the design of optimal monetary policy – depends crucially on how households, firms, and financial market investors form their expectations regarding the future course of policy.
3 This recognition of the central role of expectations in macroeconomic outcomes led to the discovery of the time-inconsistency problem, a concept that sounds highfalutin but is actually quite intuitive. 4 This problem arises whenever the possibility of short-run gains creates a temptation to renege on an existing plan, even though following that plan would produce a better outcome over the longer run.