Time Inconsistency

The majority view in the profession now appears to be that monetary and fiscal policy do have temporary effects on output. Even so, RE had yet a third salvo on the intellectual status quo: time inconsistency. Time inconsistency arises whenever (i) agents' actions today depend on the policymakers action tomorrow, (ii) the agents' action a affects the policymaker's social welfare function, and (iii) there is no commitment technology through which a policymaker can tie itself to announced policies.

There is now a large literature on the concept. The first two readings explain how time inconsistency arises and its implications for the conduct of policy.  Kydland and Prescott (1977) is the classic reference on the concept of time inconsistency, and contains applications to both monetary and fiscal policy. The essence of the papers is (i) that time-consistent policies are inferior to the optimal, commitment policy, (ii) optimal control, which implicitly assumes there is a commitment technology, will often yield incorrect predicts about policy choices.

Barro and Gordon (1983) ask how a central bank can construct some sort of commitment mechanism through reputation effects. Rogoff's paper is a nice piece that explains how time inconsistency can make it in our interests to appoint a central banker who is more conservative than society.

The supplementary readings are all notable papers on the topic of time consistency.  Fischer (1980) studies the Kydland-Prescott fiscal policy problem in more detail and is an excellent read, while Barro (1983) further explores and refines his ideas about reputation. Chari and Kehoe (1990) explores the link between the macroeconomic models and game theory concepts, Stokey (1989) shows that the reputation solution is quite generally applicable, not just to questions of monetary or fiscal policy. Bulow and Rogoff (1989) apply the concept to the question of forgiving third world debt.
Many central banks have resolved the time inconsistency issue by effectively behaving as though they have imposed rules on themselves. What do these rules look like? John Taylor pioneered the analysis f central bank rules in the early 1990s (go here for his links to useful material). Kozicki (1999) asks how useful this work has been.
 
Required Readings
Kydland, Fynn E., and Edward C. Prescott (1977): "Rules Rather than Discretion: The Inconsistency of Optimal Plans", Journal of Political Economy, 85(3):473-491.
Barro Robert J., and David B. Gordon (1983): "Rules, Discretion, and Reputation in a Model of Monetary Policy." Journal of Monetary Economics, 12: 101-20.
Rogoff, Kenneth (1985): "The Optimal Degree of Commitment to an Intermediate Monetary Target." Quarterly Journal of Economics, 100:1169-1190.
 
Supplementary Readings
Fischer, Stanley (1980): "Dynamic Inconsistency, Cooperation, and the Benevolent Dissembling Government." Journal of Economic Dynamics and Control, 2:93-107.
Chari, V.V., and Patrick J. Kehoe (1990) "Sustainable Plans." Journal of Political Economy, 98(4):783-802.
Barro, Robert J. (1986): "Reputation in a Model of Monetary Policy with Incomplete Information." Journal of Monetary Economics, 17:1-20.
Persson, Torsten, and Guido Tabellini (1993):"Designing Institutions for Monetary Stability", Carnegie-Rochester Conference Series on Public Policy, 39.
Stokey, Nancy L. (1989): "Reputation and Time Consistency." American Economic Review, Papers and Proceedings, 79(2):134-139.
Bulow, Jeremy, and Kenneth Rogoff (1989): "Sovereign Debt: Is to Forgive to Forget?" American Economic Review, 79(1):43-50.
Kozicki, Sharon (1999): "How Useful are Taylor Rules for Monetary Policy?", Federal Reserve Bank of Kansas Economic Review.

All the papers listed above have been reprinted in: 
    Persson, Torsten and Guido Tabellini (1994): Monetary and Fiscal Policy. Volume I: Credibility, Cambridge, MA: MIT Press,

which contains many other interesting papers.