Asset-Market Participation, Monetary Policy Rules, and the Great Inflation

34 Pages Posted: 3 Oct 2006

See all articles by Florin Bilbiie

Florin Bilbiie

Université Paris I Panthéon-Sorbonne

Roland Straub

European Central Bank (ECB)

Date Written: September 2006

Abstract

This paper argues that limited asset market participation is crucial in explaining U.S. macroeconomic performance and monetary policy before the 1980s, and their changes thereafter. We develop an otherwise standard sticky-price dynamic stochastic general equilibrium model, which implies that at low asset-market participation rates, the interest rate elasticity of output (the slope of the IS curve) becomes positive - that is, non-Keynesian. Remarkably, in that case, a passive monetary policy rule ensures equilibrium determinacy and maximizes welfare. Consequently, we argue that the policy of the Federal Reserve System in the pre-Volcker era, often associated with a passive monetary policy rule, was closer to optimal than conventional wisdom suggests and may thus have remained unchanged at a fundamental level thereafter. We provide institutional and empirical evidence for our hypothesis, in the latter case using Bayesian estimation techniques, and show that our model is able to explain most features of the Great Inflation.

Keywords: Great Inflation, Limited Asset Market Participation, Passive Monetary Policy

JEL Classification: E31, E32, E44, E52, E58, E65, N12, N22

Suggested Citation

Bilbiie, Florin O. and Straub, Roland, Asset-Market Participation, Monetary Policy Rules, and the Great Inflation (September 2006). IMF Working Paper No. 06/200, Available at SSRN: https://ssrn.com/abstract=934459

Florin O. Bilbiie

Université Paris I Panthéon-Sorbonne ( email )

12 place du Panthéon
Paris, 75005
France

Roland Straub (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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