Bad Luck, Bad Policy, and Learning? A Markov-Switching Approach to Understanding Postwar U.S. Macroeconomic Dynamics
34 Pages Posted: 3 Jul 2016 Last revised: 1 Jul 2017
Date Written: June 30, 2017
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 medium scale 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 late 1960s through the 1970s, specifically supply side shocks that behaved as destabilizing forces driving macroeconomic fluctuations. 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 the 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: Suggested Citation