Indeterminacy and Learning: An Analysis of Monetary Policy in the Great Inflation

51 Pages Posted: 10 Feb 2014 Last revised: 11 Feb 2014

See all articles by Thomas Lubik

Thomas Lubik

Federal Reserve Banks - Federal Reserve Bank of Richmond

Christian Matthes

Federal Reserve Bank of Richmond

Multiple version iconThere are 2 versions of this paper

Date Written: February 1, 2014

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. Specifically, 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.

Keywords: Federal Reserve, Great Moderation, Bayesian Estimation, Least Squares Learning

JEL Classification: C11, C32, E52

Suggested Citation

Lubik, Thomas and Matthes, Christian, Indeterminacy and Learning: An Analysis of Monetary Policy in the Great Inflation (February 1, 2014). CAMA Working Paper No. 16/2014. Available at SSRN: https://ssrn.com/abstract=2393129 or http://dx.doi.org/10.2139/ssrn.2393129

Thomas Lubik (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

Christian Matthes

Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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