Monetary Policy Mistakes and the Evolution of Inflation Expectations

48 Pages Posted: 19 Jul 2010

See all articles by Athanasios Orphanides

Athanasios Orphanides

Massachusetts Institute of Technology (MIT) - Sloan School of Management; Asia School of Business

John C. Williams

Federal Reserve Bank of New York

Multiple version iconThere are 2 versions of this paper

Date Written: June 2010

Abstract

What monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s? We use counterfactual simulations of an estimated model of the U.S. economy to evaluate alternative monetary policy strategies. We show that policies constructed using modern optimal control techniques aimed at stabilizing inflation, economic activity, and interest rates would have succeeded in achieving a high degree of economic stability as well as price stability only if the Federal Reserve had possessed excellent information regarding the structure of the economy or if it had acted as if it placed relatively low weight on stabilizing the real economy. Neither condition held true. We document that policymakers at the time both had an overly optimistic view of the natural rate of unemployment and put a high priority on achieving full employment. We show that in the presence of realistic informational imperfections and with an emphasis on stabilizing economic activity, an optimal control approach would have failed to keep inflation expectations well anchored, resulting in highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly successful in the presence of informational imperfections. This robust monetary policy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s.

Keywords: Great Inflation, model uncertainty, naturalrate of unemployment, rational expectations, robust control

JEL Classification: E52

Suggested Citation

Orphanides, Athanasios and Williams, John C., Monetary Policy Mistakes and the Evolution of Inflation Expectations (June 2010). CEPR Discussion Paper No. DP7892, Available at SSRN: https://ssrn.com/abstract=1640414

Athanasios Orphanides (Contact Author)

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

100 Main Street
E62-416
Cambridge, MA 02142
United States

HOME PAGE: http://mitsloan.mit.edu/faculty/detail.php?in_spseqno=54058

Asia School of Business ( email )

Jalan Kuching, Kuala Lumpur, Wilayah Persekutuan K
Kuala Lumpur, MA
Malaysia

John C. Williams

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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