Working Paper: CEPR ID: DP8101
Authors: Patrick Minford; Zhirong Ou
Abstract: Using indirect inference based on a VAR we confront US data from 1972 to 2007 with a standard New Keynesian model in which an optimal timeless policy is substituted for a Taylor rule. We find the model explains the data both for the Great Acceleration and the Great Moderation. The implication is that changing variances of shocks caused the reduction of volatility. Smaller Fed policy errors accounted for the fall in inflation volatility. Smaller supply shocks accounted for the fall in output volatility and smaller demand shocks for lower interest rate volatility. The same model with differing Taylor rules of the standard sorts cannot explain the data of either episode. But the model with timeless optimal policy could have generated data in which Taylor rule regressions could have been found, creating an illusion that monetary policy was following such rules.
Keywords: bootstrap; great moderation; indirect inference; monetary policy; new keynesian model; shocks; VAR; Wald statistic
JEL Codes: E32; E42; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| reduction in the variances of various economic shocks (E39) | transition from the great acceleration to the great moderation in the US economy (N12) |
| smaller Fed policy errors (E52) | decrease in inflation volatility (E31) |
| smaller supply shocks (E39) | reduction in output volatility (E39) |
| smaller demand shocks (E39) | lower interest rate volatility (E43) |
| improved monetary management by the Fed (E52) | stabilization of inflation (E63) |