Monetary Policy and Macroeconomic Stability Revisited

Abstract

A large literature has established that the Fed's change from a passive to an active policy response to inflation led to U.S. macroeconomic stability after the Great Inflation of the 1970s. This paper revisits the literature's view by estimating a generalized New Keynesian model using a full-information Bayesian method that allows for equilibrium indeterminacy and adopts a sequential Monte Carlo algorithm. The estimated model shows an active policy response to inflation even during the Great Inflation. Moreover, a more active policy response to inflation alone does not suffice for explaining the macroeconomic stability, unless it is accompanied by a change in either trend inflation or policy responses to the output gap and output growth. Our model empirically outperforms its canonical counterpart that is similar to models used in the literature, thus giving strong support to our view.