Working Paper: CEPR ID: DP4865
Authors: Athanasios Orphanides; John C. Williams
Abstract: We develop an estimated model of the US economy in which agents form expectations by continually updating their beliefs regarding the behaviour 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 favour of policies that concentrated on the achievement of price stability, contributing to the subsequent improvements in macroeconomic performance of the US economy.
Keywords: learning; monetary policy; rational expectations; stagflation
JEL Codes: E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Misperceptions of the natural rate of unemployment (J64) | Aggressive monetary policy (E63) |
| Aggressive monetary policy (E63) | Destabilization of inflation expectations (E31) |
| Had policymakers reacted less aggressively to perceived unemployment gaps (J68) | Inflation expectations would have remained anchored (E31) |
| Less aggressive monetary policy (E63) | Better stabilization of both inflation and unemployment (E63) |