The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations

FRB of San Francisco Working Paper No. 2003-24

30 Pages Posted: 5 May 2004

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 3 versions of this paper

Date Written: December 2003

Abstract

We develop an estimated model of the U.S. economy in which agents form expectations by continually updating their beliefs regarding the behavior of the economy and monetary policy. We explore the effects of policymakers' misperceptions of the natural rate of unemployment during the late 1960s and 1970s on the formation of expectations and macroeconomic outcomes. We find that the combination of monetary policy directed at tight stabilization of unemployment near its perceived natural rate and large real-time errors in estimates of the natural rate uprooted heretofore quiescent inflation expectations and destabilized the economy. Had monetary policy reacted less aggressively to perceived unemployment gaps, inflation expectations would have remained anchored and the stagnation of the 1970s would have been avoided. Indeed, we find that less activist policies would have been more effective at stabilizing both inflation and unemployment. We argue that policymakers, learning from the experience of the 1970s, eschewed activist policies in favor of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance of the U.S. economy.

Suggested Citation

Orphanides, Athanasios and Williams, John C., The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations (December 2003). FRB of San Francisco Working Paper No. 2003-24, Available at SSRN: https://ssrn.com/abstract=530844 or http://dx.doi.org/10.2139/ssrn.530844

Athanasios Orphanides

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 (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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