Abstract
We argue in this paper that the Great Inflation of the 1970s can be understood as the result of equilibrium indeterminacy in which loose monetary policy engendered excess volatility in macroeconomic aggregates and prices. We show, however, that the Federal Reserve inadvertently pursued policies that were not anti-inflationary enough because it did not fully understand the economic environment it was operating in. Speci cally, it had imperfect knowledge about the structure of the U.S. economy and it was subject to data misperceptions. The real-time data flow at that time did not capture the true state of the economy, as large subsequent revisions showed. It is the combination of learning about the economy and, more importantly, the use of data riddled with measurement error that resulted in policies, which the Federal Reserve believed to be optimal, but when implemented led to equilibrium indeterminacy in the economy.
Highlights
There are three strands of narratives about the Great Inflation and the Great Moderation in the academic literature
We argue in this paper that the Great Inflation of the 1970s can be understood as the result of equilibrium indeterminacy in which loose monetary policy engendered excess volatility in macroeconomic aggregates and prices
That the Federal Reserve inadvertently pursued policies that were not anti-inflationary enough because it did not fully understand the economic environment it was operating in
Summary
There are three strands of narratives about the Great Inflation and the Great Moderation in the academic literature. Collard and Dellas (2010) demonstrate in an, albeit calibrated, New Keynesian DSGE model that monetary misperceptions, interpreted as the difference between real-time and revised data, are an important driver of observed economic fluctuations through a monetary policy transmission channel They show that this type of error imparts endogenous persistence on inflation dynamics without the need to introduce exogenous sources, such as price indexation. Following the contributions of Sims and Zha (2006), Davig and Leeper (2007), and Farmer, Waggoner, and Zha (2009), who study Markov-switching in the parameters of a structural VAR and in the coefficients of a monetary policy rule, Liu, Waggoner and Zha (2011), Bianchi (2013), and Davig and Doh (2013) estimate regimes and coefficients within the context of New Keynesian models They find evidence of a regime shift in the early 1980s, supporting the argument in Lubik and Schorfheide (2004) who imposed this break date exogenously.
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