Working Paper: NBER ID: w17080
Authors: Athanasios Orphanides; John 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. We show 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 had possessed 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 of the 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 keep inflation expectations well anchored, resulting in high and highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly effective at stabilizing inflation and unemployment in the presence of informational imperfections. This robust monetary policy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s.
Keywords: No keywords provided
JEL Codes: E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary policy frameworks utilized by the Federal Reserve (E52) | Inflation outcomes during the Great Inflation period (E31) |
| Overly optimistic view of the natural rate of unemployment (E24) | Failure of monetary policy to stabilize inflation (E31) |
| High priority placed on achieving full employment (E24) | Failure of monetary policy to stabilize inflation (E31) |
| Excellent information regarding the structure of the economy (P19) | Well-anchored inflation expectations (E31) |
| Prioritizing price stability over real economic activity (E64) | Economic stability (E60) |
| Optimal control policies (C61) | Reasonably well-anchored inflation expectations (E31) |
| Realistic informational imperfections (D83) | Failure of optimal control approach to stabilize inflation expectations (E61) |
| Robust first-difference policy rule (C54) | Stabilizing inflation and unemployment (E63) |
| Optimal control approach (C61) | High and volatile inflation during the 1970s (E31) |