If the Fed aims to achieve a level of unemployment below its natural rate, it must follow time-inconsistent policies.

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This statement is based on the concept of the Phillips curve, which suggests that there is an inverse relationship between unemployment and inflation. According to this theory, when unemployment is below its natural rate (also known as the non-accelerating inflation rate of unemployment or NAIRU), inflation tends to rise. To keep inflation under control, the Fed would need to tighten monetary policy, which would increase interest rates and reduce economic activity, leading to higher unemployment. However, if the Fed pursues expansionary policies to keep unemployment low, it would risk triggering inflation in the long run. This dilemma creates a time inconsistency problem because what might seem like the optimal policy in the short-term (e.g., lowering interest rates to boost employment) could have negative consequences in the future (e.g., higher inflation expectations). Hence, the Fed faces a trade-off between short-term goals and long-term objectives, which requires making difficult choices that may not be compatible with a consistent policy rule.

If the Fed Aims to Achieve a Level of Unemployment