Working Paper: CEPR ID: DP7892
Authors: Athanasios Orphanides; John C. Williams
Abstract: What monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s? We use counterfactual simulations of an estimated model of the U.S. economy to evaluate alternative monetary policy strategies. Weshow that policies constructed using modern optimal control techniques aimed at stabilizing inflation, economic activity, and interest rates would have succeeded in achieving a high degree of economic stability as well as price stability only if the Federal Reserve hadpossessed excellent information regarding the structure of the economy or if it had acted as if it placed relatively low weight on stabilizing the real economy. Neither condition held true. We document that policymakers at the time both had an overly optimistic view ofthe natural rate of unemployment and put a high priority on achieving full employment. We show that in the presence of realistic informational imperfections and with an emphasis on stabilizing economic activity, an optimal control approach would have failed to keepinflation expectations well anchored, resulting in highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly successful in the presence of informational imperfections. This robust monetarypolicy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s.
Keywords: Great Inflation; Model Uncertainty; Natural Rate of Unemployment; Rational Expectations; Robust Control
JEL Codes: E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Accurate information regarding the natural rate of unemployment (J64) | optimal control policies effectively stabilizing inflation expectations during the 1960s and 1970s (E63) |
| Federal Reserve's emphasis on stabilizing real economic activity over price stability + misperception of the natural rate of unemployment (E39) | overly expansionary policy (E62) |
| overly expansionary policy (E62) | high inflation and volatile inflation expectations (E31) |
| robust first-difference policy rule (C54) | favorable outcomes (stabilizing inflation and economic activity) during informational imperfections (E63) |
| optimal control approach is flawed (C61) | inability to account for three critical mistakes by policymakers (E65) |