Time Inconsistency is a concept that originated in the field of economics but can be applied to pretty much any situation in which a decision must be made. A decision is time inconsistent when what looks like a good choice in the short run is actually the worse decision when its effects are examined in the long run.
That may sound confusing in the abstract but it's actually a concept that you encounter nearly every day in one form or another. Let's take an example from real life. Suppose you make a New Year's resolution to start a diet and lose weight. You were going to exercise but the weather's been so horrible that you never got around to going out jogging. A few weeks later you're at an office party and there's cake being served. "I'll just eat some cake and start my diet next week" you think as you take a slice. A few weeks later you go to a wedding: "I really should have at least one slice of cake; I'll start my diet next week". Pretty soon it's June, halfway through the year, and you haven't started exercising and all the cake you've been eating has actually made you gain weight. At every point you decided to break your diet, the short-term satisfaction you got from eating the cake looked greater to you than the long-term health benefits for being in better shape.
Time inconsistency is usually used to refer to policies by large economic entities such as banks, the Fed, and the government though it can just as easily apply to individual decision-makers like the above situation. One example of this is how and when the Fed applies the short run relationship between inflation and unemployment.
When the economy goes into recession, people stop consuming expensive luxuries which means that companies have to lower their prices in order to get sales. This in turn shrinks their profit margins and they may lay off workers to compensate. This is represented by a shift in the aggregate demand curve to the left (shown by the middle graph below). So a recession is characterized by lower production (higher unemployment) and lower prices.
The Economy Before Recession The Economy In Recession The Economy After Recession
Price| \ | /SRAS Price| \ | / Price| \ | /
Level| \|/ Level| \ |/ Level| \ | /
| XE | \ Λ | \ | /
| /|\ | \ /| | \ | /
| / | \ | E'X | | \ | /
| / | \ | / \ | \|/
| / | \ | / Λ | XE"
| / | \ | / |\ | /|\
| / | \ | / | \ | / | \
| / |LRAS \AD | / | \ | / | \
|/ | \ |/ | \ | / | \
Output Output Output
Now that we are in a recession, the new equilibrium between supply and demand is at point E'. If left to its own devices, the market will (in theory) correct itself in the long run. The glut of workers--represented by the high rate of unemployment--will drive wages down because only the workers who agree to work for less will be hired. As the workers that are given higher wages are replaced by those that accept lower wages, the production costs of companies drop and they hire more workers to raise production. The reduction in input costs and the resulting increase in production shifts the Aggregate Supply short-run aggregate supply curve to the right (shown by the rightmost graph). As a result of these natural market pressures, the new, long-run equilibrium settles at point E''. This is represented by lower prices with equal employment (and production) as before the recession.
However, during a recession the Fed can interfere and influence the natural forces of the economy by increasing the money supply. This generates inflation which can either offset or overcome the deflationary pressures of the recession. The end result of the inflation caused by an increase in the money supply would be to push AD back to the right, restoring the pre-recession equilibrium.
This choice by the Fed--whether to interfere in the market or not--is an example of time inconsistency. In the short run, it looks like a good idea to lower unemployment and restore the status quo by changing monetary policy and raising inflation (returning the equilibrium to point E from point E'). However, we can see that in the long run, this ensures a higher price level than if the economy were left alone (point E''). In most situations, suffering unemployment even for a short time is unpalatable so the latter decision is usually made. However, there have been exceptions such as the intentional recession caused by Paul Volcker's monetary policy in the 1980s to end the cycle of stagflation.