Working Paper: CEPR ID: DP8555
Authors: Florin Ovidiu Bilbiie; Roland Straub
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 DSGE model, whereby at low enough asset market participation, standard aggregate demand logic is inverted: interest rate increases become expansionary. Thereby, a passive monetary policy rule ensures equilibrium determinacy and maximizes welfare, suggesting that Federal Reserve policy in the pre-Volcker era was better than conventional wisdom suggests. We provide empirical evidence consistent with this hypothesis, and study the relative merits of changes in structure and shocks for reproducing the conquest of the Great Inflation and the Great Moderation.
Keywords: aggregate demand; bayesian estimation; great inflation; great moderation; limited asset markets participation; passive monetary policy rules; real indeterminacy
JEL Codes: E31; E32; E44; E52; E58; E65; N12; N22
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| limited asset market participation (G19) | US macroeconomic performance (E66) |
| interest rate increases (E43) | aggregate demand (pre-1980s) (E00) |
| passive monetary policy rule (E63) | equilibrium determinacy (C62) |
| structural change post-1980 (L16) | increased asset market participation (G19) |
| increased asset market participation (G19) | shift in responsiveness of aggregate demand to interest rates (E43) |
| shift in the slope of the IS curve (E12) | implications for interpreting Great Inflation (E31) |
| counterfactual experiments (C93) | assessment of structural changes vs stochastic shocks (C22) |