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

36 Pages Posted: 13 May 2005

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: January 2005

Abstract

We develop an estimated model of the US 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 policy-makers' 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 here-to-fore quiescent inflation expectations and contributed to poor macroeconomic performance. Had monetary policy reacted less aggressively to perceived unemployment gaps, inflation expectations would have remained anchored and the stagflation 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 policy-makers, 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 US economy.

Keywords: Monetary policy, stagflation, rational expectations, learning

JEL Classification: E52

Suggested Citation

Orphanides, Athanasios and Williams, John C., The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning and Expectations (January 2005). Available at SSRN: https://ssrn.com/abstract=722461

Athanasios Orphanides (Contact Author)

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

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

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