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

45 Pages Posted: 3 Jul 2016 Last revised: 15 Mar 2019

See all articles by Gabriela Best

Gabriela Best

California State University, Fullerton - Mihaylo College of Business & Economics

Joonyoung Hur

Hankuk University of Foreign Studies

Date Written: June 30, 2017

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 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. In addition, the model captures non-policy related high volatility periods clustered
around the mid-to-late 1970s, specifically supply side shocks that behaved as destabilizing
forces driving macroeconomic fluctuations. We also find that the monetary policy shift toward
inflation stabilization (in the late 1970s) changed the composition of output making the
marginal efficiency of investment shock the most important contributor to the business cycle.
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 U.S.
post-war data.

Keywords: Great Inflation, Policy Preferences, Policymakers' Beliefs, Constant Gain Learning, Markov-switching DSGE Models

JEL Classification: C11, D83, E31, E50, E52, E58, E32, E44

Suggested Citation

Best, Gabriela and Hur, Joonyoung, Bad Luck, Bad Policy, and Learning? A Markov-Switching Approach to Understanding Postwar U.S. Macroeconomic Dynamics (June 30, 2017). Available at SSRN: https://ssrn.com/abstract=2803020 or http://dx.doi.org/10.2139/ssrn.2803020

Gabriela Best

California State University, Fullerton - Mihaylo College of Business & Economics ( email )

P.O. Box 6848
Fullerton, CA CA 92834-6848
United States

HOME PAGE: http://www.gabrielabest.com/

Joonyoung Hur (Contact Author)

Hankuk University of Foreign Studies ( email )

107 Imun-ro
Dongdaemun-gu
Seoul, 02450
Korea, Republic of (South Korea)
+82-2-2173-8813 (Phone)

HOME PAGE: http://sites.google.com/site/joonyhur/

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