Working Paper: NBER ID: w11147
Authors: Giorgio E. Primiceri
Abstract: This paper provides an explanation for the run-up of U.S. inflation in the 1960s and 1970s and the sharp disinflation in the early 1980s, which standard macroeconomic models have difficulties in addressing. I present a model in which rational policymakers learn about the behavior of the economy in real time and set stabilization policy optimally, conditional on their current beliefs. The steady state associated with the self-confirming equilibrium of the model is characterized by low inflation. However, prolonged episodes of high inflation ending with rapid disinflations can occur when policymakers underestimate both the natural rate of unemployment and the persistence of inflation in the Phillips curve. I estimate the model using likelihood methods. The estimation results show that the model accounts remarkably well for the evolution of policymakers' beliefs, stabilization policy and the postwar behavior of inflation and unemployment in the United States.
Keywords: inflation; unemployment; policymakers beliefs; stabilization policy
JEL Codes: E31; E32; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Policymakers' beliefs (D78) | Inflation (E31) |
| Policymakers' beliefs (D78) | Unemployment (J64) |
| Policymakers' underestimation of natural rate of unemployment (E24) | Overexpansionary policies (E62) |
| Overexpansionary policies (E62) | Higher inflation (E31) |
| Policymakers' beliefs (D78) | Stabilization policy choices (E63) |
| Stabilization policy choices (E63) | Inflation and unemployment outcomes (E31) |
| Policymakers' beliefs about inflation (E31) | Reaction to inflation (E31) |
| Reaction to inflation (E31) | Inflation rise (E31) |
| Policymakers' perceptions during overpessimism (E65) | Delayed anti-inflationary measures (E31) |