Bad Luck, Bad Policy, or Learning? A Markov-Switching Approach to Understanding Postwar U.S. Macroeconomic Dynamics

Abstract

In this paper we analyze changes in the Federal Reserve behavior and objectives since the 1960s justified by potentially evolving beliefs — through a real-time learning process — about the structure of the economy and shifts in policymakers preferences in the late 1970s. In addition, we allow for changes in the volatility of the structural shocks in a medium scale Markov-switching DSGE model. We evaluate the relative contribution of each narrative to the explanation of the Great Inflation and the Great Moderation. We argue that the interplay between central bank learning and a shift in policy makers’ preferences explains movements in the monetary instrument, and regulates equilibrium determinacy in the economy. We find evidence of “bad” policy consistent with equilibrium indeterminacy during the 1970s and “good” policy during the Great Moderation. In addition, the model captures non-policy related high volatility periods clustered around the late 1960’s through the 1970s, specifically supply side shocks that behaved as destabilizing forces driving macroeconomic fluctuations. To conclude, we observe that a change in monetary policy objectives, assumptions about policymakers’ learning process, and Markov-switching volatility are key to fit the model to the U.S. post-war data.