Monetary Policy and Macroeconomic Stability Revisited
43 Pages Posted: 17 Jul 2019
Date Written: June 26, 2019
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 model empirically outperforms canonical New Keynesian models that confirm the literature’s view. Our estimated model shows an active policy response to inflation even during the Great Inflation. More importantly, a more active policy response to inflation alone does not suffice for explaining the U.S. macroeconomic stability, unless it is accompanied by a change in either trend inflation or policy responses to the output gap and output growth. This extends the literature by emphasizing the importance of the changes in other aspects of monetary policy in addition to its response to inflation.
Keywords: Monetary policy, Great Inflation, Indeterminacy, Trend inflation, Sequential Monte Carlo
JEL Classification: C11, C52, C62, E31, E52
Suggested Citation: Suggested Citation